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Financial Accounting

Eleventh Edition

Chapter 3

Accrual Accounting and Income

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Learning Objectives

3.1 Explain how accrual accounting differs from cash-basis accounting

3.2 Apply the revenue and expense recognition principles

3.3 Adjust the accounts

3.4 Construct the financial statements

3.5 Close the books

3.6 Analyze and evaluate a company’s debt-paying ability

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Learning Objective 3.1

Explain how accrual accounting differs from cash-basis accounting

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Explain How Accrual Accounting Differs From Cash-Basis Accounting (1 of 4)

Accrual Accounting

Records impact of transactions when they occur
Required by Generally Accepted Accounting Principles (GAAP)
Records:

Revenue when earned
Expenses when incurred

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Explain How Accrual Accounting Differs From Cash-Basis Accounting (2 of 4)

Cash-Basis Accounting

Records only cash transactions

Cash receipts
Cash payments

Ignores important information
Results in incomplete financial statements
Only used by the smallest businesses

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Explain How Accrual Accounting Differs From Cash-Basis Accounting (3 of 4)

Accrual accounting records cash transactions, such as:
Collecting cash from customers
Receiving cash from interest earned
Paying salaries, rent, and other expenses
Borrowing money
Paying off loans
Issuing stock

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Explain How Accrual Accounting Differs From Cash-Basis Accounting (4 of 4)

The Time-Period Concept
Accounting information is reported at regular intervals
Basic accounting period is one year
Around 60% of large companies use the calendar year from January 1 through December 31
A fiscal year may end on a date other than December 31
Companies also prepare financial statements for interim periods

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Learning Objective 3.2

Apply the revenue and expense recognition principles

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Apply the Revenue and Expense Recognition Principles (1 of 2)

The Revenue Principle

Deals with two issues:

When to record (recognize) revenue
What amount of revenue to record

Revenue is recognized when the business transfers promised goods or services to a customer in an amount that reflects the cash (or fair market value of other consideration) that the entity expects to receive in exchange for those goods or services.

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Apply the Revenue and Expense Recognition Principles (2 of 2)

The Expense Recognition Principle

Includes two steps:

Identify all expenses incurred during the period
Measure the expenses and recognize them in the same period in which any related revenues are earned

To recognize an expense along with related revenues means to subtract expenses from related revenues to compute net income or net loss.

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Exhibit 3-2 The Expense Recognition Principle

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Learning Objective 3.3

Adjust the accounts

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Exhibit 3-3 Unadjusted Trial Balance

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Categories of Adjusting Entries

Deferrals
An adjustment for payment of an item or receipt of cash in advance.
Depreciation
Allocates the cost of a plant asset to expense over the asset’s useful life.
Accruals

The opposite of a deferral.

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Adjust the Accounts (1 of 6)

Prepaid Expenses

An expense paid in advance. Prepaid expenses are assets because they provide a future benefit for the owner.

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Prepaid Expenses (1 of 4)

Prepaid Rent: Suppose Alladin’s Travel Inc., prepays three months’ store rent ($3,000) on June 1.

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Prepaid Expenses (2 of 4)

Prepaid Rent. Throughout June, Prepaid Rent carries the balance of $3,000. At June 30, an adjusting entry is required to transfer $1,000 ($3,000 ÷ 3) from Prepaid Rent to Rent Expense.

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Prepaid Expenses (3 of 4)

Supplies. On June 2, Alladin Travel paid cash of $700 for cleaning supplies.

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Prepaid Expenses (4 of 4)

Supplies. A count at June 30 indicates that $400 of supplies remain on hand.

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Adjust the Accounts (2 of 6)

Depreciation of Plant Assets

Plant assets are long-lived tangible assets, such as land, buildings, furniture, and equipment.
Depreciation is the process of allocating cost to expense for a long-term plant asset.

Decline in usefulness
Spread the cost of the plant asset over its useful life
Exception: Land – does not decline in usefulness

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Depreciation of Plant Assets (1 of 4)

Equipment. Suppose that on June 3 Alladin Travel purchased equipment on account for $24,000

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Depreciation of Plant Assets (2 of 4)

Straight-line depreciation method:

Divide cost of the asset by its useful life
Alladin Travel Inc. Equipment:

Cost: $24,000

Useful life: 5 years

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Depreciation of Plant Assets (3 of 4)

Depreciation expense for June is recorded as follows:

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Depreciation of Plant Assets (4 of 4)

Accumulated Depreciation

Shows the sum of all depreciation expense
The balance increases over the asset’s life
Contra asset account, a normal credit balance.
A contra account has two distinguishing characteristics:

Always has a companion account
Normal balance is opposite that of the companion account

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Exhibit 3-4 Plant Assets on the Balance Sheet of Alladin Travel

Book Value: Cost of the plant asset minus accumulated depreciation

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Adjust the Accounts (3 of 6)

Accrued Expenses

A liability that arises from an expense that has not yet been paid
Not recorded daily or weekly, but rather at the end of the period as an adjusting entry

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Accrued Expenses (1 of 3)

Accrued Salary Expense. Suppose Alladin Travel, Inc. pays its employee a monthly salary of $1,800, half on the 15th and half on the last day of the month. The following calendar for June has the paydays circled:

Assume that if a payday falls on a Sunday, Alladin’s pays the employee on the following Monday.

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Accrued Expenses (2 of 3)

During June, Alladin Travel paid its employee the first half-month salary of $900.

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Accrued Expenses (3 of 3)

The second half-month amount of $900 will be paid on Monday, July 1. At June 30, therefore, Alladin Travel makes the adjusting entry.

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Adjust the Accounts (4 of 6)

Accrued Revenues

A revenue that has been earned but not yet collected.

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Accrued Revenues

Assume that on June 15 a hotel agrees to pay Alladin a commission of $600 for booking 100 clients into its hotel over the next 30 days. Alladin books 50 clients in June and 50 in July. Alladin will earn half a month’s, fee, $300, for work done June 15 through June 30.

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Adjust the Accounts (5 of 6)

Unearned Service Revenue

Receipt of cash before earning the revenue creates a liability

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Unearned Service Revenue (1 of 2)

Suppose Disneyworld Resort engages Alladin Travel, paying them commissions in advance to book clients in Disney resort hotels. Assume Disney pays Alladin $400 monthly, beginning immediately. Alladin collects the first amount on June 15.

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Unearned Service Revenue (2 of 2)

During the last 15 days of the month, Alladin Travel books four clients into Disneyworld Resort to earn ½ of the $400.

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Exhibit 3-6 Prepaid and Accrual Adjustments

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Summary of the Adjusting Process

Two purposes of the adjusting process are to

measure income, and
update the balance sheet.
Therefore, every adjusting entry affects both of the following:
Revenue or expense—to measure income
Asset or liability—to update the balance sheet

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Exhibit 3-7 Summary of Adjusting Entries

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Income Tax Accrual

Alladin Travel, Inc. would make an additional adjusting entry to accrue income tax expense of $600 and the related income tax payable as the final adjusting entry of the period.

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Exhibit 3-8 The Adjusting Process of Alladin Travel, Inc. (1 of 2)

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Exhibit 3-8 The Adjusting Process of Alladin Travel, Inc. (2 of 2)

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Adjust the Accounts (6 of 6)

The Adjusted Trial Balance

Summarizes all accounts and their final balances after all adjusting entries have been journalized and posted

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Exhibit 3-9 Trial Balance Worksheet

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Learning Objective 3.4

Construct the financial statements

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Construct the Financial Statements

The June financial statements of Alladin Travel, Inc. can be prepared from the adjusted trial balance.

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Exhibit 3-10 Income Statement

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Exhibit 3-11 Statement of Retained Earnings

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Exhibit 3-12 Balance Sheet

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Learning Objective 3.5

Close the books

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Close the Books (1 of 3)

Prepares the accounts for the next period
Close temporary accounts: accounts related to a limited period of time

Revenues
Expenses
Dividends

Do NOT close permanent accounts

Assets
Liabilities
Stockholders’ equity

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Close the Books (2 of 3)

Steps to close the books:

Debit each revenue for the amount of its credit balance. Credit Retained Earnings for the sum of all revenues.
Credit each expense account for the amount of its debit balance. Debit Retained Earnings for the sum of all expenses.
Credit the Dividends account for the amount of its debit balance. Debit Retained Earnings for the same amount.

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Exhibit 3-13 Journalizing and Posting the Closing Entries (1 of 2)

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Exhibit 3-13 Journalizing and Posting the Closing Entries (2 of 2)

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Close the Books (3 of 3)

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Classifying Assets and Liabilities Based on Their Liquidity (1 of 5)

Assets and liabilities are classified as current or long term based on liquidity
Liquidity: a measure of how quickly an item can be converted to cash

Cash is the most liquid asset
Accounts receivable is relatively liquid
Inventory is less liquid
Equipment and buildings even less liquid

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Classifying Assets and Liabilities Based on Their Liquidity (2 of 5)

Current Assets
Most liquid assets
Converted to cash, sold, or consumed with next year or business’s operating cycle
Examples include Cash, Short-term Investments, Accounts Receivable, and Prepaid Expenses

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Classifying Assets and Liabilities Based on Their Liquidity (3 of 5)

Long-Term Assets
All assets not classified as current
Plant assets (Property, Plant, and Equipment)
Examples include Land, buildings, Furniture and Fixtures, and Equipment

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Classifying Assets and Liabilities Based on Their Liquidity (4 of 5)

Current Liabilities
Debts that must be paid within one year or within the operating cycle if longer than a year
Examples include Accounts Payable, Notes Payable due within one year, Salary Payable, Unearned Revenue, Interest Payable, and Income Tax Payable

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Classifying Assets and Liabilities Based on Their Liquidity (5 of 5)

Long-Term Liabilities
All liabilities that are not current
Many Note Payables are long-term

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Exhibit 3-14 Classified Balance Sheet of the Walt Disney Company

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Formats for the Financial Statements

Balance Sheet Formats

Report
Account

Income Statement Formats

Single-step
Multi-step

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Exhibit 3-15 The Walt Disney Company Income Statement in Multistep Format

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Learning Objective 3.6

Analyze and evaluate a company’s debt-paying ability

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Analyze and Evaluate a Company’s Debt-Paying Ability (1 of 3)

Net Working Capital
Represents operating liquidity
Generally, companies should have excess current assets over current liabilities

Total current assets − Total current liabilities

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Analyze and Evaluate a Company’s Debt-Paying Ability (2 of 3)

Current Ratio
Represents operating liquidity
Companies prefer a high current ratio
Many successful businesses operate with current ratios between 1.20 – 1.50

Total current assets ÷ Total current liabilities

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Analyze and Evaluate a Company’s Debt-Paying Ability (3 of 3)

Debt Ratio
Measures debt-paying ability
The proportion of a company’s assets financed with debt
A low debt ratio is safer than a high debt ratio

Total liabilities ÷ Total assets

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How Do Transactions Affect the Ratios? (1 of 8)

a. Issued stock and received cash of $50 million.

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How Do Transactions Affect the Ratios? (2 of 8)

Before:

After:

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How Do Transactions Affect the Ratios? (3 of 8)

b. Paid cash to purchase buildings for $20 million.

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How Do Transactions Affect the Ratios? (4 of 8)

c. Made a $30 million sale on account.

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How Do Transactions Affect the Ratios? (5 of 8)

d. Collected the account receivable of $30 million.

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How Do Transactions Affect the Ratios? (6 of 8)

e. Accrued expenses at year-end, $40 million.

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How Do Transactions Affect the Ratios? (7 of 8)

f. Recorded depreciation, $80 million.

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How Do Transactions Affect the Ratios? (8 of 8)

g. Earned interest revenue and collected cash, $40 million.

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