Accrual Accounting & Income
Chapter 3
3-1
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Accrual vs. Cash-Basis Accounting
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
3-2
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Learning Objective 1
Relate accrual accounting and cash flows
3-3
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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
3-4
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Time-Period Concept
• 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
3-5
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Learning Objective 2
Apply the revenue and matching principles
3-6
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The Revenue Principle
• Revenue is recorded when 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
3-7
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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
3-8
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Expenses
• 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
3-9
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Learning Objective 3
Adjust the accounts
3-10
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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
3-11
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Categories of Adjusting Entries
• Deferrals
• Depreciation
• Accruals
3-12
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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
3-13
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Prepaid Expenses
•
•
•
•
Expenses paid in advance
Include prepaid rent and supplies
Asset is recorded when purchased
Adjustment needed to record amount used
3-14
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Prepaid Rent Example
• Suppose on April 1 on a company paid
$12,000 for one year’s rent in advance
JOURNAL
Date
1-Apr
Accounts
Prepaid rent
Debit
Credit
$12,000
Cash
$12,000
3-15
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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
3-16
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$12,000 Prepaid Rent
$9,000
$3,000
December 31
April 1,
current year
April 1 to December 31 = 9 months
April 1,
following
year
3 out of 12 months
of rent remains
9 out of 12 months of rent has expired
9/12 x $12,000 = $9,000
3/12 x $12,000 = $3,000
3-17
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Prepaid Rent Example
• Dec 31 – Adjust Prepaid Rent account for
amount expired
JOURNAL
Date
12-31
Accounts
Debit
Rent Expense
Prepaid Rent
Credit
$9,000
$9,000
3-18
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Prepaid Rent
Apr 1
$12,000
Dec 31
Rent Expense
$9,000
$9,000
Represents
amount
expired
$3,000
End-of-year
balance
Dec 31
Represents
amount
remaining
3-19
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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
3-20
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Supplies Example
Supplies
Balance per ledger
$3,200
What amount of supplies
was used?
Balance per
physical count
$500
Subtract the balance
per count from the
balance per ledger
3-21
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Supplies Example
• Dec 31 – Adjust Supplies account for amount
used
JOURNAL
Date
12-31
Accounts
Debit
Supplies Expense
Supplies
Credit
$1,700
$1,700
3-22
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Supplies
$3,200
Dec 31 $1,700
Dec 31
$1,700
Represents
amount
used
$500
End-of-year
balance
Supplies Expense
Represents
amount on
hand
3-23
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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
3-24
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Accumulated Depreciation
• Account that shows the sum of
depreciation expense of the plant asset
• Contra-asset
 Always has a companion account
 Normal credit balance
3-25
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Depreciation Example
• A company purchases equipment for
$50,000
• The estimated useful life of the equipment
is five years
50,000/5 years
=
$5,000
annual
depreciation
3-26
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Depreciation Example
• Dec 31 – Adjusting entry to record
depreciation of equipment
JOURNAL
Date
12-31
Accounts
Debit
Depreciation Expense
Accumulated Depreciation
Credit
$5,000
$5,000
3-27
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Depreciation – Balance Sheet
Balance Sheet
Plant assets:
Equipment
Less: Accum. Depr.
$50,000
(5,000)
$45,000
3-28
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Accrued Expenses
• Expense incurred before cash is paid
• Result in a liability
• Common accrued expenses:
 Salaries
 Interest
 Taxes
3-29
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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
3-30
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$10,000 Salaries
$6,000
Monday,
December 29
$4,000
Wednesday,
December 31
year end
Friday,
January 2
pay day
Monday through Wednesday = 3 days
3 out of 5 days of salaries expense has been incurred
3/5 x $10,000 = $6,000
3-31
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Accrued Salary Expense Example
• Dec 31 – Record accrued salary expense
JOURNAL
Date
12-31
Accounts
Debit
Salary expense
Salary payable
Credit
$6,000
$6,000
3-32
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Accrued Revenues
• Companies often earn revenue before
cash is received
• Results in an accrued revenue
 Receivable recorded
3-33
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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
3-34
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Accrued Salary Expense Example
• Dec 31 – Record accrued revenue
JOURNAL
Date
12-31
Accounts
Debit
Accounts Receivable
Service Revenue
Credit
$5,000
$5,000
3-35
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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
3-36
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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
3-37
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Unearned Revenue Example
• Nov 1 – Record advance payment received by
customer
JOURNAL
Date
11-1
Accounts
Debit
Cash
Credit
$18,000
Unearned revenue
$18,000
3-38
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$18,000
$12,000
$6,000
December 31
November 1,
current year
November 1 to December 31 = 3 months
January 31,
following
year
1 out of 3 months
remains unearned
2 out of 3 months of
revenue has been earned
2/3 x $18,000 = $12,000
1/3 x $18,000 = $6,000
3-39
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Unearned Revenue Example
• Dec 31 – Record portion of unearned revenue
that has been earned
JOURNAL
Date
12-31
Accounts
Debit
Unearned revenue
Service revenue
Credit
$12,000
$12,000
3-40
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Unearned Revenue
Dec 31
$12,000
Nov 1 $18,000
Dec 31
$12,000
Represents
amount
earned
$6,000
End-of-year
balance
Service Revenue
Represents
amount
unearned
3-41
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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
3-42
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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
3-43
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Learning Objective 4
Prepare the financial statements
3-44
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Income Statement
• Reports net income or loss
• Revenues minus expenses
• Net income flows to Retained Earnings
Statement
3-45
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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
3-46
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Balance Sheet
• Reports assets, liabilities and equity
• Shows that the accounting equation is in
balance
3-47
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INCOME STATEMENT
NET
INCOME
RETAINED EARNINGS
STATEMENT
ENDING
RETAINED
EARNINGS
BALANCE SHEET
3-48
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Learning Objective 5
Close the books
3-49
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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
3-50
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Temporary and Permanent Accounts
Temporary
• Revenues, Expenses
and Dividends
• Closed
• Balances represent a
period of time
Permanent
• Asset, liability and
equity accounts
• Not closed
• Ending balance of
one period carries
over to following
period
3-51
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Closing Entries
• Debit each Revenue account for the
amount in its credit balance
 Retained earnings is credited
• Credit each Expense account for the
amount in its debit balance
 Retained earnings is debited
R E D
• Credit Dividends for the amount in its debit
balance
 Retained earnings is debited
3-52
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E3-29
• Dec 31 – Close Revenues
JOURNAL
Date
12-31
Accounts
Debit
Service Revenue
Other revenue
Retained earnings
Credit
$23,600
600
$24,200
3-53
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E3-29
Which account
would be
debited? Total
the expenses
for the amount
• Dec 31 – Close expenses
JOURNAL
Date
Accounts
31-Dec ________________________
Cost of services sold
Debit
Credit
_________
$11,600
Selling, general & admin exp
$6,900
Depreciation expense
$4,100
Income tax expense
$500
3-54
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E3-29
• Dec 31 – Close Dividends
JOURNAL
Date
12-31
Accounts
Debit
Retained earnings
Dividends
Credit
$400
$400
3-55
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E3-29
Retained earnings
Expenses
Dividends
$23,100
$400
$1,900
Balance 12-31-X1
$24,200
Revenues
$2,600
Balance 12-31-X2
Determine net income.
Remember revenues
minus expenses
3-56
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Classifying Assets & Liabilities
• Current and long-term classifications are based
on liquidity
 How quickly item is converted to in cash
• Current assets will be converted to cash, sold or
used during the next year
• Long-term assets include plant assets
• Current liabilities must be paid in the next 12
months
• Long-term liabilities have due dates more than
one year from balance sheet date
3-57
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Classified Balance Sheet
• Places assets into meaningful categories
• Categories:





Current assets
Long-term investments
Property, plant and equipment
Intangible assets
Other assets
3-58
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Balance Sheet Formats
• Report format
 Assets at the top
 Followed by liabilities and stockholders’ equity
• Account format
 Assets on the left
 Liabilities and stockholders’ equity on the right
3-59
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Income Statement Formats
• Single-step
 All revenues and gains grouped together
 All expenses and losses grouped together
• Multi-step
 Includes useful subtotals
 Gross profit
• Net revenues minus cost of goods sold
 Income from operations
 Net income
3-60
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Learning Objective 6
Use two new ratios to evaluate a business
3-61
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Current ratio
• Measure company’s ability to pay current
liabilities with current assets
• Rule of thumb:
 Strong current ratio is 1.50
Current assets
Current liabilities
3-62
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Debt Ratio
• Proportion of assets that is financed with
debt
• High debt ratio indicates more risk
Total liabilities
Total assets
3-63
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S3-14
Current ratio:
Current assets = Cash + Accounts Receivable + Inventories +
Other current assets
$900 + $27,700 + $33,000 = $4,800 = $66,400
Total Current liabilities = $53,600
Current ratio = 66,400 / 53,600
Current ratio = ______
3-64
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S3-14
Debt ratio:
Total liabilities = Current liabilities + Long-term liabilities
$53,600 + $13,500 = $67,100
Total assets = Current assets + Property & Equipment, net +
Other assets
$66,400 + $7,200 + $24,300 = 97,900
Debt ratio = $67,100 / $97,900
Debt ratio = .69
3-65
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End of Chapter Three
3-66
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