Accrual Accounting and
the Financial Statements
Chapter 3
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Learning Objective 1
Relate accrual accounting and cash
flows.
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Accrual Accounting vs Cash
Basis Accounting
 Accrual Accounting - records the
impact of a business event as it
occurs
 Cash Basis – records only
transactions in which cash is
received or paid
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The Time-Period Concept
Financial statements are prepared
for specific periods and at regular
intervals.
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Learning Objective 2
Apply the revenue and matching
principles.
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Revenue Principle
 Revenue is recorded when it is
earned.
 The amount of revenue to record is
the cash value of goods transferred
to customer.
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The Matching Principle
 Record all expenses incurred
during the accounting period
 Match expenses against revenues
earned
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Learning Objective 3
Update the financial statements by
adjusting the accounts.
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Air & Sea Unadjusted Trial
Balance April 30, 20x3
Account
Cash
Accounts receivable
Supplies
Prepaid rent
Furniture
Accounts payable
Unearned service revenue
Common stock
Retained earnings
Dividends
Service revenue
Salary expense
Utilities expense
Total
Debit
$24,800
2,250
700
3,000
16,500
Credit
13,100
450
20,000
11,250
3200
$7,000
950
400
$51,800
$51,800
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Categories of Accounting
Adjustments
 Deferrals
 Depreciation
 Accruals
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Prepaid Expenses: Rent
On April 1, 20x3, Air & Sea Travel
prepays three months office rent.
Prepaid Rent
3,000
Cash
3,000
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Prepaid Expenses: Rent
What is the adjusting entry on April
30?
Date
General Journal
Accounts and Explanations
PR
April 30 Rent Expense
Prepaid Rent
To record rent expense
($3,000 x 1/3)
Debit
Credit
1,000
1,000
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Prepaid Expenses: Supplies
On April 2, 20x3, Air & Sea Travel
paid cash of $700 for office
supplies.
Supplies
700
Cash
700
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Prepaid Expenses: Supplies
An inventory at month end indicated
that $400 in office supplies
remained.
Supplies
4/2 700 4/30 300
Bal. 400
Supplies Expense
4/30 300
Bal. 300
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Depreciation
 Allocation of the cost of a plant
asset to expense over the asset’s
useful life
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Depreciation of Plant Assets
On April 3, the business purchased
furniture on account for $16,500.
The furniture is expected to last 5
years.
Furniture
16,500
Accounts Payable
16,500
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Depreciation of Plant Assets
 Straight-line method of depreciation
allocates equal amounts each
accounting period.
 $16,000 ÷ 5 years = $3,300 per
year
 $3,300 ÷12 months = $275 per
month
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Depreciation of Plant Assets
What is the adjusting entry on April
30?
Date
General Journal
Accounts and Explanations
PR
April 30 Depreciation Expense, Furniture
Accumulated Depreciation,
Furniture
To record depreciation
Debit
Credit
275
275
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Book Value
The net amount of a plant asset (cost
minus accumulated depreciation)
Plant Assets of Air & Sea at April 30, 20x5
Furniture
$
16,500
Less Accumulated Depreciation
(275) $
Building
$
48,000
Less Accumulated Depreciation
(200)
Book value of plant assets
$
16,225
47,800
64,025
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Accrued Expense
 A liability that arises from an expense
that has not yet been paid.
 Air & Sea Travel pays its employees a
monthly salary of $1,900, half on the
15th and half on the last day of the
month. If a payday falls on the
weekend, Air & Sea pays the employee
on the following Monday.
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Accrued Expenses
Salary Expense
4/15 950
4/30 950
Bal. 1,900
Cash
4/15 950
Salary Payable
4/30 950
Bal. 950
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Accrued Revenue
 A revenue that has been earned
but not received in cash.
 Bank One hires Air & Sea Travel on
April 15 to arrange travel services
on a monthly basis. Bank One will
pay the travel agency $500
monthly, with the first payment on
May 15.
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Accrued Revenues
Adjusting entry:
Date
General Journal
Accounts and Explanations
PR
April 30 Accounts Receivable
Service Revenue
To accrue service revenue
Debit
Credit
250
250
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Unearned Revenue
 An obligation arising from receiving
cash before providing a service.
 Plantation Foods engages Air & Sea
Travel agreeing to pay the agency $450
monthly, beginning immediately. Air &
Sea Travel collects the first amount on
April 20 and earns one-third the last 10
days.
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Unearned Revenues
Date
General Journal
Accounts and Explanations
PR
April 20 Cash
Unearned Revenue
Received advanced payment
Date
General Journal
Accounts and Explanations
PR
April 30 Unearned Revenue
Revenue
To record revenue earned
($450 x 1/3)
Debit
Credit
450
450
Debit
Credit
150
150
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Air & Sea Travel
Work Sheet
For the Month Ended April 30, 20x5
Unadjusted Trial
Account
Balance
Adjustments
Title
Debit
Credit
Debit
Credit
Cash
24,800
Accounts receivable
2,250
e.
250
Supplies
700
b. 300
Prepaid rent
3,000
a. 1000
Furniture
16,500
Accum depr, furn
c. 275
Accounts payable
13,100
Salary payable
d. 950
Income tax payable
g. 540
Unearned svc rev.
450 f.
150
Common stock
20,000
Retained earnings
11,250
Dividends
3200
Service revenue
$7,000
e. 250
f. 150
Salary expense
950
d.
950
Rent expense
a.
1000
Supplies expense
b.
300
Depr. Exp, furn.
c.
275
Utilities expense
400
Income tax expense
g.
540
Total
$51,800 $51,800
3,465
3,465
Step 2
Plan
Adjustments
Step 2
Prepare Adjusted
Trial Balance
Adjusted Trial
Balance
Debit
Credit
24,800
2,500
400
2,000
16,500
275
13,100
950
540
300
20,000
11,250
3,200
$7,400
Step 1
Prepare
Unadjusted
Trial Balance
1,900
1,000
300
275
400
540
53,815
53,815
Learning Objective 4
Prepare the financial statements.
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Air & Sea Travel, Inc.
Income Statement
Month Ended April 30, 20x5
Revenue:
Service revenue
Expenses:
Salary expense
$1,900
Rent expense
1,000
Utilities expense
400
Supplies expense
300
Depreciation expense
275
Income before tax
Income tax expense
Net income
$7,400
3,875
$3,525
540
$2,985
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©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren
Air & Sea Travel, Inc.
Statement of Retained Earnings
Month Ended April 30, 20x5
Retained earnings, April 1, 20x5
Add: Net income
Less: Dividends
Retained earnings, April 30, 20x5
$11,250
2,958
$14,235
( 3,200)
$11,035
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Air & Sea Travel, Inc.
Balance Sheet
April 30, 20x5
Assets
Cash
$24,800
Accounts receivable
2,500
Supplies
400
Prepaid rent
2,000
Furniture
$16,500
Less:
Accumulated
depreciation ( 275) 16,225
Total assets
$45,925
Liabilities
Accounts payable
$13,100
Salary payable
950
Unearned revenue
300
Income tax payable
540
Total liabilities
$14,890
Stockholders’ Equity
Common stock
$20,000
Retained earnings
11,035
Total
$31,031
Total liabilities and
stockholders’ equity $45,925
Learning Objective 5
Close the books.
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Closing Entries
 Prepare the accounts for the next
period’s transactions.
 Transfer the revenue, expense, and
dividends balances to Retained
Earnings.
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Which Accounts
Need To Be Closed?
 Temporary accounts are closed
 Revenue
 Expense
 Dividends
 Permanent accounts are not closed
 Assets
 Liabilities
 Stockholders’ equity
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Journalizing the Closing Entries
General Journal
Date
April 30
April 30
April 30
Accounts and Explanations
PR
Debit
Service Revenue
Retained Earnings
7,400
Retained Earnings
Rent Expense
Salary Expense
Supplies Expense
Depreciation Expense
Utilities Expense
Income Tax Expense
4,415
Retained Earnings
Dividends
3,200
Credit
7,400
1,000
1,900
300
275
400
540
3,200
Posting the Closing Entries
Rent Expense
1,000 1,000
Salary Expense
950
950
1,900 1,900
Other Expenses
1,515 1,515
Retained Earnings
4,415 11,250
3,200
7,400
11,035
Service Revenue
7,000
250
150
7,400 7,400
Dividends
3,200 3,200
Classifying Assets and
Liabilities
 List assets and liabilities in order of
their relative liquidity.
 Liquidity - how quickly an item can
be converted to cash.
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Classifying Assets and
Liabilities
Current assets
Long-term assets
Current liabilities
Long-term liabilities
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Learning Objective 6
Use the current ratio and the debt
ratio to evaluate a business.
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Current Ratio
 Measures company’s ability to pay
current liabilities with current assets
Total current assets
Total current liabilities
Rule of thumb: A strong current ratio is 2.00
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Debt Ratio
 The proportion of assets that is
financed with debt.
 Measures business’s ability to pay
total liabilities
Total liabilities
Total assets
A low debt ratio is safer than a high debt ratio.
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End of Chapter 3
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