ACG2021
Financial Accounting
Chapter 3
Using 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.
ACG2021
Financial 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.
Deferred Asset Adjustment
 Adjustment records the effect of using up an
Asset
Assets
“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
Debit
+
Credit
-
Expenses
Debit
+
Credit
-
Adjusting Prepaid Expenses
To record $3,000 paid for 3 months rent on April 1, 20X3.
DATE
ACCOUNTS AND EXPLANATION
Apr 1
Prepaid Rent (1,000 x 3)
Cash
Paid 3 months’ rent in advance
Prepaid Rent
3,000
DEBIT
CREDIT
3,000
3,000
Cash
3,000
Adjusting Prepaid Expenses
To adjust for one month’s rent expired at April 30.
DATE
ACCOUNTS AND EXPLANATION
Apr 30
Rent Expense (1,000/3)
Prepaid Rent
Expensed one month’s rent
Rent
Expense
1,000
DEBIT
CREDIT
1,000
1,000
Prepaid
Rent
1,000
Adjusting Prepaid Expenses
The following shows the effect of the adjustment.
Prepaid Rent
Apr 1
3,000
Bal. 2,000
Apr 30 1,000
Rent Expense
Apr 30 1,000
Bal. 1,000
Adjusting Supplies
To record the purchase of supplies.
DATE
ACCOUNTS AND EXPLANATION
Apr 2
Supplies
Cash
Paid cash for supplies
Supplies
700
DEBIT
CREDIT
700
700
Cash
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
Apr 30
Supplies Expense
Supplies
To record Supplies Expense
Supplies
Expense
300
DEBIT
CREDIT
300
300
Supplies
300
Adjusting Supplies
The following shows the effect of the adjustment.
Supplies
Apr 1
700
Bal. 400
Apr 30 300
Supplies Expense
Apr 30 300
Bal. 300
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
Apr 20
Cash
450
Unearned Service Revenue
Received cash for revenue in advance
Cash
450
DEBIT
Unearned
Service Revenue
450
CREDIT
450
Unearned Revenue
To record revenues earned at the end of the month.
DATE
ACCOUNTS AND EXPLANATION
Apr 30
Unearned Service Revenue (450/3)
150
Service Revenue
150
To record unearned service revenue that has been
earned
Unearned
Service Revenue
150
DEBIT
Service
Revenue
150
CREDIT
Unearned Revenue
The following shows the effect of the adjustment.
Unearned Service
Revenue
Apr 30
150 Apr 20
Bal.
Service
Revenue
450
300
7,000
Apr 30 250
Apr 30 150
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
Expenses
 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 Credit
+
Liability
 Debit Expense, Credit Liability
Debit
-
Credit
+
Accrued Expenses
To record salaries expense during the month.
DATE
ACCOUNTS AND EXPLANATION
Apr 15
Salaries Expense
Cash
To pay salaries
Salaries
Expense
950
DEBIT
CREDIT
950
950
Cash
950
Accrued Expenses
To adjust salaries expense at the end of the month.
DATE
ACCOUNTS AND EXPLANATION
Apr 30
Salaries Expense
Salaries Payable
To accrue salaries expense
Salaries
Expense
950
DEBIT
CREDIT
950
950
Salaries
Payable
950
Accrued Expenses
The following shows the effect of the adjustment.
Salaries
Payable
Salaries Expense
Apr 30
Bal.
950
950
Apr 30
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
Apr 30
Accounts Receivable
Service Revenue
To accrue service revenue
Accounts
Receivable
250
DEBIT
CREDIT
250
250
Service
Revenue
250
Accrued Revenue
The following shows the effect of the adjustment.
Accounts
Service
Receivable
Revenue
7,000
Apr 30
Bal.
250
7,250
2,250
Apr 30
Bal.
250
2,500
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.
Summary of Adjusting Entries
ACG2021
Financial Accounting
Closing the Books
Adjusted Trial Balance
Stockholders’ Equity Accounts
Expanded Accounting Equation
Liabilities
Assets
=
Stockholders’
Equity
Common
Stock
+
Retained
Earnings
Dividends
+
Revenues
Expenses
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
Apr 30
Apr 30
Service Revenue
Retained Earnings
Retained Earnings
Rent Expense
Salary Expense
Supplies Expense
Depreciation Expense
Utilities Expense
Income Tax Expense
Retained Earnings
Dividends
7,400
7,400
4,415
1,000
1,900
300
275
400
540
3,200
3,200
Closing Accounts
Retained Earnings after closing entries:
Retained Earnings
Expenses
Dividends
4,415
3,200
Beg. Bal 11,250
Revenues 7,400
End Bal
11,035
ACG 2021
Financial 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
Balance Sheet – Account Format
Balance Sheet – Report Format
Income Statement – Single Step
Income Statement – Multi Step
ACG 2021
Financial Accounting
Accounting Ratios
Accounting Ratios
Current Ratio =
Debt Ratio
=
Total Current Assets
Total Current Liabilities
Total Liabilities
Total Assets
Current Ratio
Ability to pay current liabilities with current
assets
Rule of Thumb
1.5 or greater is a strong current ratio
What does this mean?
Avg. between 1.2 and 1.5
1.0 or below is considered low
What does this mean?
Debt Ratio
Proportion of Assets financed with Debt
Ability of a company to pay liabilities
Lower ratio is safer then higher
Why?
End of Chapter 3