CHAPTER 3
Investment Banking Basics:
Accrual Accounting and the
Financial Statements
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3-1
THE BUSINESS CYCLE
• Businesses pay cash to buy goods and
services
• Businesses sell goods and services,
receiving cash to complete the cycle
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THE BUSINESS CYCLE
Collection of
the receivable
3
Entity
has a
receivable
1
Entity
has
cash
Purchase of
inventory
2
Entity
holds
inventory
Sale of inventory on account
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3-3
ACCRUAL-BASIS ACCOUNTING
VS. CASH-BASIS ACCOUNTING
• Accrual accounting
– Recognizes the impact of a business event
as it occurs
• Revenues are recorded as they are earned
• Expenses are recorded as they are incurred
– Is based on a conceptual framework that
includes a number of accounting concepts
and principles
– Is required by GAAP
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3-4
THE TIME-PERIOD CONCEPT
• Accountants slice time into small
segments and prepare financial
statements to show progress for specific
time periods
– The most basic accounting period is one
year
– Companies prepare financial statements
for interim periods of less than one year
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THE REVENUE PRINCIPLE
• The revenue principle tells accountants
– When to record revenue with a journal
entry
• Revenue is recorded when it is earned
• It is earned when the business has delivered a
completed good or service to the customer
– The amount of revenue to record
• The amount is equal to the cash value of the
goods or services transferred to the customer
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I plan to have you
make my travel
arrangements
March
12
Air & Sea
Travel, Inc.
No transaction has occurred
Situation 1 - Do Not Record Revenue
April
2
Air & Sea
Travel, Inc.
The client has taken a trip arranged
by Air & Sea Travel
Situation 2 - Record Revenue
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THE MATCHING PRINCIPLE
• The matching principle
– Is the basis for recording expenses
– Directs accountants to
• Identify all expenses incurred during the
accounting period
• Measure the expenses
• Match expenses against revenues during the
same period
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THE MATCHING PRINCIPLE
The matching principle matches the expense
of a period against the revenue earned
during the period. To match an expense
means to subtract the expense from the
revenue in order to measure net income or
net loss
Revenue
Expense
=
Net income
Revenue
Net income
or
Expense
=
(Net loss)
Net loss
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THE MATCHING PRINCIPLE
• A natural link (cause and effect) exists
between revenues and some types of
expenses
– Sales commissions
– Cost of goods sold
• Some expenses are not linked with
sales but with a particular time period
– Rent expense
– Salary expense
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3-10
UPDATING THE ACCOUNTS
FOR THE FINANCIAL
STATEMENTS:
The Adjustment Process
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THE ADJUSTMENT PROCESS
• The adjustment process begins with the
trial balance
• The unadjusted trial balance lists the
accounts and their balances after the
period’s transactions have been
recorded
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THE ADJUSTMENT PROCESS
• These trial balance accounts are
incomplete because they omit certain
revenue and expense transactions that
affect more than one accounting period
• The accrual basis requires adjustment
at the end of the period to produce
correct balances for the financial
statements
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3-13
Air & Sea Travel, Inc.
Unadjusted Trial Balance
April 30, 2001
Account Title
Cash
Accounts receivable
Supplies
Prepaid rent
Furniture
Accounts payable
Unearned service revenue
Common stock
Retained earnings
Dividends
Service revenue
Salary expense
Utilities expense
Total
Balance
Debit
Credit
$24,800
2,250
700
3,000
16,500
$13,100
450
20,000
11,250
3,200
7,000
950
400
$51,800 $51,800
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THE ADJUSTMENT PROCESS
• Consider the Supplies account
– Supplies is adjusted once a month
– The amount on the trial balance represents
the cost of supplies available for use during
the month
– The supplies on hand at the end of the
month must be counted to determine the
correct amount to report on the balance
sheet
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3-15
THE ADJUSTMENT PROCESS
The adjustment of Supplies (and Supplies Expense) at
the end of the accounting period
March 31
Supplies available
for use during April
April 30
Supplies on hand at
Supplies expense
=
April 30
for April
TOTAL COST
ASSET
=
EXPENSE
$700
$400
=
$300
The adjusting entry updates both the Supplies asset account
and the Supplies Expense account
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THE ADJUSTMENT PROCESS
• Accountants make adjusting entries in
the journal at the end of the period to
enter adjustments into the accounting
records
• Adjusting entries
– Assign revenues to the period in which
they are earned and expenses to the
period in which they are incurred
– Update the asset and liability accounts
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THE ADJUSTMENT PROCESS
Summary of the Accounting Cycle
January 1
Transactions are
recorded all
during the period
December 31
Adjustments are made
at the end of the
period, but before the
financial statements
are prepared
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THE ADJUSTMENT PROCESS
• Adjusting entries can be grouped into
three basic categories:
– Deferrals
• An adjustment of an asset or a liability for which
the business paid or received cash in advance
– Depreciation
• The systematic allocation of the cost of a plant
asset to expense over the asset’s useful life
– Accruals
• The recording of an expense or a revenue
before paying or receiving cash
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PREPAID EXPENSES
PREPAID RENT
Suppose Air & Sea Travel prepays three months’ rent on
April 1, 20X1. If the lease specifies a monthly rental
amount of $1,000, the entry to record the payment for
three months debits Prepaid Rent as follows:
Apr. 1
Prepaid Rent (1,000 x 3)
3,000
Cash
3,000
Paid three months’ rent in advance
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PREPAID EXPENSES
PREPAID RENT
At April 30, Prepaid Rent is adjusted to remove one
month’s expense from the asset account. The
adjustment transfers one-third of the asset balance
from Prepaid Rent to Rent Expense as follows:
Apr. 30
Rent Expense (3000 x1/3)
1,000
Prepaid Rent
1,000
To record rent expense
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PREPAID EXPENSES
PREPAID RENT
After posting, Prepaid Rent and Rent Expense appear
as follows:
Prepaid Rent
Rent Expense
Apr 1. 3,000 Apr. 30 1,000
Apr. 30 1,000
Bal.
Bal.
2,000
1,000
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PREPAID EXPENSES
SUPPLIES
On April 2, Air & Sea Travel paid cash of $700 for
office supplies
Apr. 2
Supplies
700
Cash
Paid cash for supplies
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Harrison &
3-23
PREPAID EXPENSES
SUPPLIES
To measure the business’s supplies expense
during April, the owners count the supplies on
hand at the end of the month. The count
indicates that supplies costing $400 remain.
Subtracting the entity’s $400 supplies on hand
at the end of April from the cost of supplies
available during April ($700) measures supplies
expense during the month ($300).
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PREPAID EXPENSES
SUPPLIES
The April 30 adjusting entry to update the Supplies
account and to record the Supplies Expense for the
month is as follows:
Apr 30
Supplies Expense ( $700 - $400)
300
Supplies
300
To record supplies expense
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3-25
PREPAID EXPENSES
SUPPLIES
After posting the accounts appear as follows:
Supplies
Apr 2.
700 Apr. 30
Bal.
400
Supplies Expense
300
Apr. 30
300
Bal.
300
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3-26
DEPRECIATION OF
PLANT ASSETS
• Plant assets are
– Long-lived tangible assets, such as land,
buildings, furniture, machinery, and
equipment used in the operations of the
business
• Depreciation is
– The process of allocating the cost of the
decline in value of a plant asset to expense
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3-27
DEPRECIATION OF
PLANT ASSETS
On April 3, Air & Sea Travel purchased furniture on
account for $16,500 and made the following entry:
Apr. 3
Furniture
16,500
Accounts Payable
16,500
Purchased office furniture on account
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3-28
DEPRECIATION OF
PLANT ASSETS
The straight-line method of depreciation gives an annual
depreciation expense of $3,300
$16,000/5 years = $3,300 per year
Depreciation for the month of April is $275
$3,300/12 months = $275 per month
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DEPRECIATION OF
PLANT ASSETS
Depreciation expense for April is recorded as follows:
Apr 30
Depreciation Expense - Furniture
275
Accumulated Depreciation - Furniture
275
To record depreciation on furniture
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DEPRECIATION OF
PLANT ASSETS
• The Accumulated Depreciation account
– Shows the cumulative sum of all
depreciation expense from the date of
acquiring the asset
– Is a contra asset account
• An asset account with a normal credit balance
• A contra account
– Always has a companion account
– Always has a normal balance that is
opposite that of the companion account
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DEPRECIATION OF
PLANT ASSETS
After posting, the Furniture, Accumulated Depreciation Furniture, and Depreciation Expense - Furniture
accounts appear as follows:
Furniture
Apr. 3 16,500
Bal.
16,500
Accumulated Depreciation
Furniture
Depreciation Expense
Furniture
Apr. 30 275
Apr. 30 275
Bal.
Bal.
275
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275
Harrison &
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DEPRECIATION OF
PLANT ASSETS
Book value is the net amount of a plant
asset (cost minus accumulated
depreciation)
Plant Assets:
Furniture
Less Accumulated Depreciation
Book value
$16,500
(275)
$16,225
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ACCRUED EXPENSES
An accrued expense is a liability that
arises from an expense that the business
has incurred but has not yet paid
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ACCRUED EXPENSES
SALARY EXPENSE
Air & Sea Travel pays its employee a monthly salary of
$1,900, half on the 15th and half on the last day of the
month. During April, the agency paid the employee’s
first half-month salary of $950 and made the following
entry:
Apr. 15
Salary Expense
950
Cash
950
To pay salary
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ACCRUED EXPENSES
SALARY EXPENSE
Because April 30, the second payday of the month,
falls on a Saturday, the second half-month amount of
$950 will be paid on Monday, May 2. At April 30, Air &
Sea’s accountant adjusts for additional salary expense
and salary payable of $950 by recording an increase in
each account as follows:
Apr. 30
Salary Expense
950
Salary Payable
950
To accrue salary expense
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ACCRUED EXPENSES
SALARY EXPENSE
After posting, the Salary Payable and Salary Expense
accounts appear as follows:
Salary Payable
Salary Expense
Apr. 30
950
Apr. 15 950
Apr. 30 950
Bal.
950
Bal.
1,900
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ACCRUED REVENUES
An accrued revenue is a revenue that
has been earned but not received in
cash
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ACCRUED REVENUES
Guerrero Tours hires Air & Sea Travel on April 15 to
perform services on a monthly basis. Guerrero will pay
the travel agency $500 monthly, with the first payment
on May 15. On April 30, Air & Sea Travel makes the
following adjusting entry for half a month’s fee:
Apr. 30
Accounts Receivable ($500 x 1/2)
250
Service Revenue
250
To accrue service revenue
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ACCRUED REVENUES
Posting this adjusting entry has the following effects on
these two accounts:
Accounts Receivable
Service Revenue
2,250
Apr. 30
250
Bal.
2,500
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7,000
Apr. 30 250
Bal.
7,250
Harrison &
3-40
UNEARNED REVENUES
An unearned revenue is an obligation
arising from receiving cash in advance of
providing a product or a service
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UNEARNED REVENUES
Baldwin Investment Bankers agrees to pay the travel
agency $450 monthly. If Air & Sea Travel collects the first
amount on April 20, the increases in assets and liabilities
are recorded as follows:
Apr. 20
Cash
450
Unearned Service Revenue
450
Received revenue in advance
Unearned Service Revenue is a liability because it represents Air &
Sea’s obligation to perform service for the client
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UNEARNED REVENUES
During the last 10 days of the month, the travel agency
will earn one-third of the $450. The accountant makes the
following adjustment:
Apr. 30
Unearned Service Revenue (450 x 1/3)
150
Service Revenue
150
To record unearned service revenue that has
been earned
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3-43
UNEARNED REVENUES
After posting, the balance of these two accounts appears
as follows:
Unearned Service
Revenue
Apr. 30
150 Apr. 20
Bal.
Service Revenue
450
300
7,000
Apr. 30
250
Apr. 30
150
Bal.
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7,400
3-44
PREPAID- AND ACCRUALTYPE ADJUSTMENTS
PREPAIDS - The cash transaction occurs initially
Initially
Later
Prepaid
Pay cash and
Expenses record an asset:
Prepaid expense xxx
Cash
xxx
Record an expense and
decrease the asset:
Expense
xxx
Prepaid
Expense
xxx
Unearned Receive cash and
Revenues record unearned revenue:
Cash
xxx
Unearned
Revenue
xxx
Record a revenue and
decrease unearned revenue:
Unearned
Revenue
xxx
Revenue
xxx
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3-45
PREPAID- AND ACCRUALTYPE ADJUSTMENTS
ACCRUALS – The cash transaction occurs later
Initially
Later
Accrued
Record an expense
Expenses and the related payable:
Expense
xxx
Payable
xxx
Pay cash and
decrease the payable:
Payable
xxx
Cash
xxx
Accrued
Record a revenue
Revenues and the related receivable:
Receivable
xxx
Revenue
xxx
Receive cash and
decrease the receivable:
Cash
xxx
Receivable
xxx
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3-46
SUMMARY OF THE
ADJUSTING PROCESS
Type of Account
Category of Adjusting Entry
Prepaid expense
Depreciation
Accrued expense
Accrued revenue
Unearned revenue
Debited
Credited
Expense
Expense
Expense
Asset
Liability
Asset
Contra asset
Liability
Revenue
Revenue
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THE ADJUSTED
TRIAL BALANCE
The adjusted trial balance lists the
accounts, along with their adjusted
balances
Trial Balance
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3-48
Air & Sea Travel, Inc.
Preparation of Adjusted Trial Balance
April 30, 2001
Trial Balance
Account Title
Debit
Cash
Accounts receivable
Supplies
Prepaid rent
Furniture
Accumulated depr. – Furniture
Accounts payable
Salary payable
Unearned service revenue
Income tax payable
Common stock
Retained earnings
Dividends
Service revenue
24,800
2,250
700
3,000
16,500
Rent expense
Salary expense
Supplies expense
Depreciation expense
Utilities expense
Income tax expense
Credit
Adjustments
Debit
Adjusted Trial
Balance
Credit
(e) 250
(b) 300
(a) 1,000
(c)
275
(d)
950
(g)
540
(e)
(f)
250
150
Debit
24,800
2,500
400
2,000
16,500
275
13,100
950
300
540
20,000
11,250
13,100
450
(f)
150
20,000
11,250
3,200
3,200
7,000
(a) 1,000
(d) 950
(b) 300
(c) 275
950
(g)
51,800
540
3,465
7,400
1,000
1,900
300
275
400
540
400
51,800
Credit
3,465
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53,815
53,815
Harrison &
3-49
PREPARING THE FINANCIAL
STATEMENTS FROM THE
ADJUSTED TRIAL BALANCE
The April financial statements of Air & Sea
Travel can be prepared from the adjusted
trial balance
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3-50
Air & Sea Travel, Inc.
Trial Balance
April 30, 2001
Adjusted Trial
Balance
Account Title
Debit
Cash
Accounts receivable
Supplies
Prepaid rent
Furniture
Accumulated depr. – Furniture
Accounts payable
Salary payable
Unearned service revenue
Income tax payable
Common stock
Retained earnings
Dividends
Service revenue
Rent expense
Salary expense
Supplies expense
Depreciation expense
Utilities expense
Income tax expense
24,800
2,500
400
2,000
16,500
Credit
275
13,100
950
300
540
20,000
11,250
3,200
7,400
1,000
1,900
300
275
400
540
53,815
Balance Sheet
Statement of
Retained Earnings
Income Statement
53,815
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AIR & SEA TRAVEL, INC.
Income Statement
Month Ended April 30, 2001
Revenue:
Service revenue
Expenses:
Salary expense
Rent expense
Utilities expense
Supplies expense
Depreciation expense
Income before taxes
Income tax expense
Net Income
AIR & SEA TRAVEL, INC.
Statement of Retained Earnings
Month Ended April 30, 2001
$7,400
$1,900
1,000
400
300
275
Retained earnings, March 31, 2001
Add: Net income for the month
3,875
3,525
540
$2,985
Less: Dividends
Retained Earnings, April 30, 2001
$ 11,250
2,985
14,235
3,200
$11,035
Air & Sea Travel, Inc.
Balance Sheet
April 30, 2001
Assets
Liabilities
Cash
Accounts receivable
Supplies
Prepaid rent
Furniture
$16,500
Less Accumulated
Depreciation
275
$24,800
2,500
400
2,000
Accounts payable
$13,100
Salary payable
950
Unearned service revenue
300
Income tax payable
540
Total Liabilities
$14,890
16,225
Total assets
$45,925
Stockholders’ Equity
Common stock
20,000
Retained earnings
11,035
Total stockholders’ equity 31,035
Total liabilities and
stockholders’ equity
$45,925
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3-52
ETHICAL ISSUES IN
ACCRUAL ACCOUNTING
• Ethical issues include
– “Managing” earnings to meet established
goals or budgets
– Misrepresenting company assets,
liabilities, revenues, and expenses to
financial statement users
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CLOSING THE BOOKS
• Temporary (nominal) accounts are
– Revenue, expense, and dividends
accounts
– Closed at the end of the accounting period
• Permanent (real) accounts are
– Assets, liabilities, and stockholders’ equity
accounts
– Are not closed at the end of the period
because their balances are not used to
measure income
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3-54
CLOSING THE BOOKS
• Closing entries transfer revenue,
expense, and dividends balances from
their respective accounts to the
Retained Earnings account
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CLOSING THE BOOKS
• The following are the steps in closing
the accounts of a corporation:
Debit each revenue account for the
amount of its credit balance. Credit
Retained Earnings for the sum of the
revenues
• This entry transfers the sum of the revenues to
the credit side of Retained Earnings
Credit each expense account for the
amount of its debit balance. Debit Retained
Earnings for the sum of the expenses
• This entry transfers the sum of the Harrison
expenses
to
&
3-56
the debit side of Retained Earnings
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CLOSING THE BOOKS
Credit the Dividends account for the
amount of its debit balance. Debit the
Retained Earnings account
• This entry transfers the dividends amount to the
debit side of the Retained Earnings account
If Air & Sea Travel closes the books at the
end of April, the following slides present the
complete closing process for the business
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3-57
Journalizing
Closing Entries

Apr. 30
Service Revenue
7,400
Retained Earnings


30
30
Retained Earnings
7,400
4,415
Rent Expense
1,000
Salary Expense
1,900
Supplies Expense
300
Depreciation Expense
275
Utilities Expense
400
Income Tax Expense
540
Retained Earnings
3,200
Dividends
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e
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3,200
Harrison &
3-58
Posting Closing Entries:
Rent Expense
Service Revenue
Adj. 1,000
7,000
Adj. 250
Adj. 150
Bal. 1,000 Clo. 1,000
Salary Expense
950
Adj. 950
Bal. 1,900 Clo. 1,900
Supplies Expense
Adj. 300
Clo, 7,400


Retained Earnings
11,250
Clo. 4,415
300
Clo. 3,200 Clo. 7,400
Depreciation Expense
Bal 11,035
Bal. 300 Clo.
Adj. 275
Bal. 275 Clo.
Bal. 7,400
Dividends
275
Bal. 3,200 Clo. 3,200
Utilities Expense

Adj. 400
Bal. 400 Clo.
400
Income Tax Expense
Adj. 540
Adj. = Amount posted from an adjusting entry; Clo. = Amount posted
from a closing entry; Bal. = Balance
As arrow shows, it is not necessary to make a separate closing entry for
each expense. In one closing entry, record one debit to Retained
Bal. 540 Clo. 540
Earnings and a separate credit to each expense account
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3-59
Horngren
DETAILED CLASSIFICATION
OF ASSETS AND LIABILITIES
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• Liquidity is a measure of how quickly an
item can be converted to cash
• Balance sheets list assets and liabilities
in the order of their relative liquidity
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ASSETS
• Current assets
– Are assets that are expected to be
converted to cash, sold, or consumed
during the next 12 months or within the
business’s normal operating cycle if longer
than a year
– Include Cash, Accounts Receivable, Notes
Receivable, and Prepaid Expenses merchandising entities include Inventory in
current assets
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ASSETS
• Long-term assets
– Are all assets that are not classified as
current assets. They are not held for sale,
but rather are used to operate the business
– Include plant assets (Property, Plant, and
Equipment), Land, Buildings, Furniture and
Fixtures, and Equipment
– Include investments in Available-for-Sale
Securities, investments in Held-to-Maturity
Securities, and Other Assets
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LIABILITIES
• Current liabilities
– Are debts that are due to be paid within
one year or within the entity’s operating
cycle if longer than a year
– Include Accounts Payable, Notes Payable
due within one year, Salary Payable,
Unearned Revenue, Interest Payable, and
Income Tax Payable
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LIABILITIES
• Long-term liabilities
– Are all liabilities that are not classified as
current
– Include Notes Payable - Long Term
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DIFFERENT FORMATS FOR
THE FINANCIAL STATEMENTS
• Balance sheet formats
– The account format
• Lists the assets at left and the liabilities and
stockholders’ equity at right
– The report format
• Lists the assets at the top, followed by the
liabilities and stockholders’ equity below
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DIFFERENT FORMATS FOR
THE FINANCIAL STATEMENTS
• Income statement formats
– A single-step income statement
• Lists all the revenues together under a heading
such as Revenues or Revenues and Gains.
The expenses appear in a separate category
titled Expenses, Costs and Expenses, or
Expenses and Losses
– A multi-step income statement
• Contains a number of subtotals to highlight
important relationships among revenues and
expenses
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MULTI-STEP INCOME STATEMENT
Net sales revenue
$150,000
Cost of goods sold
80,000
Gross margin
70,000
Operating expenses
(listed individually)
40,000
Income from operations
30,000
Other income (expense):
Interest revenue
$2,000
Interest expense
(9,000)
Gain on sale of equipment 3,000 (4,000)
Income before tax
26,000
Income tax expense
10,000
Net income
$ 16,000
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USE OF ACCOUNTING
INFORMATION IN DECISION
MAKING
ACCOUNTING RATIOS
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CURRENT RATIO
Current ratio =
Total current assets
Total current liabilities
• The current ratio
– Is the ratio of any entity's current assets to
its current liabilities
– Measures the company’s ability to pay
current liabilities with current assets
A rule of thumb: A strong current ratio is 2.00
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DEBT RATIO
Total liabilities
Debt ratio =
Total assets
• The debt ratio
– Is the ratio of total liabilities to total assets
– Indicates the proportion of a company’s
assets that is financed with debt
– Measures a business’s ability to pay both
current and long-term debts - total liabilities
A low debt ratio is safer than a high debt ratio
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End of Chapter 3
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