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Accrual Accounting and IncomeChapter 3
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Explain how accrual accounting differs from cash-basis accounting
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ACCRUAL ACCOUNTING CASH-BASIS ACCOUNTING
• Records impact of transactions when they occur
• Required by Generally Accepted Accounting Principles (GAAP)
• Records:▫ Revenue when earned▫ Expenses when incurred
• Records only cash transactions▫ Cash receipts▫ Cash payments
• Ignores important information
• Results in incomplete financial statements
• Only used by the smallest businesses
Accrual vs. Cash-Basis Accounting
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Accrual Accounting
•Records both cash and noncash transactions
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Cash transactions Noncash transactions
Collecting payments from customers
Sales on account
Receiving interest earned Purchases on account
Borrowing money Accrual of expenses not yet paid
Paying expenses Depreciation expense
Paying off loans Usage of prepaid expenses
Issuing stock Earning of revenue when cash was collected in advance
Time Period Concept
•Accounting information is reported at regular intervals▫Basic accounting period is one year
•Calendar year▫January 1 – December 31
•Fiscal year▫12-month period ending on a date other
than December 31•Interim periods
▫Month or quarterCopyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.
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Apply the revenue and expense recognition principles
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Revenue Principle
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Expense Recognition Principle
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Adjust the accounts
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Adjusting the Accounts
•Financial statements issued at end of period
•Several accounts on trial balance need to be brought up-to-date▫Certain transactions have not been
recorded
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Categories of Adjustments
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Deferrals
•Business has paid or received cash in advance
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Depreciation
•Allocates cost of plant assets to expense over useful lives
•Represents wear-and-tear and obsolescence
•Examples of plant assets:▫Buildings▫Equipment▫Furniture
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Accruals
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Prepaid Expenses
•Recorded as assets when paid in advance
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JOURNAL
Date Accounts Debit Credit
Jun 1 Prepaid rent 3,000
Cash 3,000
Jun 2 Supplies 700
Cash 700
Prepaid Expenses
•Expensed when expired or used
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JOURNAL
Date Accounts Debit Credit
Jun 30 Rent expense 1,000
Prepaid rent 1,000
Jun 30 Supplies expense 300
Supplies 300
Prepaid Rent
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Prepaid rent
Jun 1 3,000 Jun 301,000
2,000
Rent expense
1,000Jun 30
Amount expiredAmount expired
Amount remainingAmount
remaining
Balance Sheet
Balance Sheet
Income Statemen
t
Income Statemen
t
Supplies
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Supplies
Jun 2 700 Jun 30300
400
Supplies expense
Amount usedAmount usedAmount on hand
Amount on hand
Balance Sheet
Balance Sheet
Income Statemen
t
Income Statemen
t
Jun 30 300
Depreciation
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JOURNAL
Date Accounts Debit Credit
Jun 3 Equipment 24,000
Accounts payable 24,000
Jun 30
Depreciation expense 400
Accumulated depreciation 400
$24,000/5 = $4,800 annual depreciation $4,800/12 = $400 monthly depreciation
Depreciation
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Equipment
Jun 3 24,000
Depreciation Expense
400Jun 30
Balance Sheet
Balance Sheet Income
Statement
Income Statemen
tAccumulated Depreciation
Jun 30400
Accumulated Depreciation
•Sum of all depreciation expense▫Increases over asset’s life
•Contra-asset▫Normal credit balance▫Companion account is asset
•Book value▫Cost of plant asset less accumulated
depreciation
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Book Value
Partial Balance SheetJune 30, 2012
Equipment $24,000
Less: Accumulated Depreciation
(400)
Book value $23,600
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Accrued Expenses
•Expenses incurred before cash is paid•Results in a liability•Examples:
▫Salaries▫Interest
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Accrued Salaries
June
Sun. Mon. Tues. Wed. Thur.
Fri. Sat.
1
2 3 4 5 6 7 8
9 10 11 12 13 14 15
16 17 18 19 20 21 22
23 24 25 26 27 28 29
30
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Pay day
Pay day
Accrued Salaries
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JOURNAL
Date Accounts Debit Credit
Jun 15 Salary expense 900
Cash 900
Jun 30 Salary expense 900
Salary payable 900
Accrued Salaries
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Salary Payable
Jun 30900
900
Salary Expense
900Jun 15
June’s salaryJune’s salaryAmount owed
Amount owed
Balance Sheet
Balance Sheet
Income Statemen
t
Income Statemen
t
900
1,800
Jun 30
Accrued Revenue
•Revenue earned but not yet received•Increases receivables and revenue
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JOURNAL
Date Accounts Debit Credit
Jun 30 Accounts receivable 300
Service revenue 300
Unearned Revenue
•Receive cash before revenue is earned•Creates a liability
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JOURNAL
Date Accounts Debit Credit
Jun 15 Cash 400
Unearned revenue 400
Unearned Revenue
•When revenue is earned▫Liability is reduced▫Revenue is increased
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JOURNAL
Date Accounts and explanation Debit Credit
Jun 30 Unearned revenue 200
Service revenue 200
Prepaids and Accruals
PREPAIDS –CASH FIRST
FIRST LATER
Prepaid expenses
Prepaid expense Expense
Cash Prepaid expense
Unearned revenues
Cash Unearned revenue
Unearned revenue Revenue
ACCRUALS – CASH LATER
FIRST LATER
Accrued expenses
Expense Payable
Payable Cash
Accrued revenues
Receivable Cash
Revenue Receivable
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Summary of the Adjusting Process•Two purposes of adjusting process
▫Measure income▫Update balance sheet
•Every adjusting entry affects at least one:▫Revenue or expense▫Asset or liability
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Summary of Adjusting Entries
Type of Account
Category of Adjustment Debit Credit
Prepaid expense Expense Asset
Depreciation Expense Contra asset
Accrued expense Expense Liability
Accrued revenue Asset Revenue
Unearned revenue Liability Revenue
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Exercise 3-24A
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JOURNAL
Date Accounts Debit Credit
(a) Interest expense 9,600
Interest payable 9,600
(b) Interest receivable 4,900
Interest revenue 4,900
(c) Unearned rent revenue 3,000
Rent revenue 3,000
Exercise 3-24A
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JOURNAL
Date Accounts Debit Credit
(d) Salary expense 7,600
Salary payable 7,600
(e) Supplies expense 1,800
Supplies 1,800
(f) Depreciation expense 16,000
Accumulated depreciation 16,000
Exercise 3-24A
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Partial Balance SheetDecember 31, 2012
Equipment $ 80,000
Less: Accumulated Depreciation
(16,000)
Book value $64,000
The Adjusted Trial Balance
•Prepared after adjustments are journalized and posted
•Useful step in preparing financial statements
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Construct the financial statements
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The Financial Statements
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Flow of Data in Financial Statements
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Income Statement
Revenues $$,$$$
Less: Expenses ($$,$$$)
Net Income $$,$$$
Statement of Retained Earnings
Retained earnings, beginning balance
$$,$$$
Plus: Net income $$,$$$
Less: Dividends ($,$$$)
Retained earnings, ending balance
$$,$$$
Flow of Data in Financial Statements
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Statement of Retained Earnings
Retained earnings, beginning balance
$$,$$$
Plus: Net income $$,$$$
Less: Dividends ($,$$$)
Retained earnings, ending balance
$$,$$$
Balance Sheet
Current assets $$,$$$ Liabilities $$,$$$
Plant assets $$,$$$ Common stock $$,$$$
Other assets $$,$$$ Retained earnings $$,$$$
Total assets$$$,$$
$Total liabilities & stockholders’ equity $$$,$$$
Close the books
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Closing the Books
•Prepares the accounts for next period•Sets revenues, expenses, and dividends to
zero
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Closing the Books
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Closing Entries
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Exercise 3-29A
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JOURNAL
Date Accounts Debit Credit
Service revenue 23,900
Other revenue 400
Retained earnings 24,300
Retained earnings 22,000
Cost of services sold 11,000
Selling, general, & admin. expenses
6,400
Depreciation expense 4,100
Income tax expense 500
Exercise 3-29A
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JOURNAL
Date Accounts Debit Credit
Retained earnings 300
Dividends 300
Revenues ExpensesNet
Income$24,300 $22,000 $2,300
Exercise 3-29A
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Retained Earnings
2,600 Beginning Balance
24,300 Revenues300
22,000
Dividends
Expenses
4,600Ending Balance
Classifying Assets & Liabilities
•Classified as current or long-term based on liquidity▫How quickly an item can be converted to
cash
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Cash Most liquid
Accounts receivable Very liquid
Inventory Somewhat liquid
Plant assets Not liquid
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Classified Balance Sheet
•Categorizes and subtotals assets and liabilities
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Assets Liabilities
Current assets Current liabilities
Long-term investments Long-term liabilities
Property, plant, and equipment
Intangible assets
Other assets
Report Format Account Format
• Assets listed at the top• Liabilities and equity
beneath
• Assets on the left• Liabilities and equity on
the right
Balance Sheet Formats
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Single-Step Multi-Step
• All revenues grouped together
• All expenses grouped together
• Shows subtotals to emphasize relationships
• Includes ▫ Gross profit▫ Income from operations▫ Income before taxes▫ Net income
Income Statement Formats
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Analyze and evaluate a company’s debt-paying ability
Net Working Capital
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Current assets
Current liabilitie
s
Current Ratio
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Current assets
Current liabilities
Measures ability to pay current liabilities
Strong current ratio = 1.50
Debt Ratio
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Total assets
Total liabilities
Measures ability to pay all liabilities
Low debt ratio is safer than high debt ratio
Transactions Affect on Ratios
•Increase revenue and decrease costs▫Results in increase in current assets and
net income•Sell stock
▫Increases cash and equity•Borrow less money
▫Decreases liabilities
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