ACG2021 Financial Accounting Chapter 3 Using Accrual Accounting to Measure Income

ACG2021Financial Accounting

Chapter 3Using Accrual Accounting to

Measure Income

Learning ObjectivesRelate accrual accounting and

cash accountingApply the revenue and matching

principlesUpdate the financial statements by

adjusting the accountsClose the booksUse 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 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.


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.


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 “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

Assets

Debit+

Credit-

Expenses

Debit+

Credit-

Adjusting Prepaid ExpensesTo record $3,000 paid for 3 months rent on April 1, 20X3.

DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT

Apr 1 Prepaid Rent (1,000 x 3) 3,000Cash 3,000

Paid 3 months’ rent in advance

Prepaid Rent

3,000

Cash

3,000

Adjusting Prepaid ExpensesTo adjust for one month’s rent expired at April 30.


Apr 30 Rent Expense (1,000/3) 1,000Prepaid Rent 1,000

Expensed one month’s rent

Rent Expense

1,000

PrepaidRent

1,000

Adjusting Prepaid ExpensesThe following shows the effect of the adjustment.

Prepaid RentApr 1 3,000 Apr 30 1,000

Bal. 2,000

Rent ExpenseApr 30 1,000

Bal. 1,000

Adjusting SuppliesTo record the purchase of supplies.


Apr 2 Supplies 700Cash 700

Paid cash for supplies

Supplies

700

Cash

700

Adjusting SuppliesTo 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 SuppliesTo adjust for supplies used during April.


Apr 30 Supplies Expense 300Supplies 300

To record Supplies Expense

Supplies Expense

300

Supplies

300

Adjusting SuppliesThe following shows the effect of the adjustment.

SuppliesApr 1 700 Apr 30 300

Bal. 400

Supplies ExpenseApr 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 RevenueTo record cash received in advance from customers.


Apr 20 Cash 450Unearned Service Revenue 450

Received cash for revenue in advance

Cash

450

UnearnedService Revenue

450

Unearned RevenueTo record revenues earned at the end of the month.


Apr 30 Unearned Service Revenue (450/3) 150Service Revenue 150

To record unearned service revenue that has beenearned

UnearnedService Revenue

150

Service Revenue

150

Unearned RevenueThe following shows the effect of the adjustment.

ServiceRevenue

Apr 30 250

Bal. 7,400

Unearned ServiceRevenue

Apr 30 150

Bal. 300

Apr 20 450 7,000

Apr 30 150

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

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 Expense, Credit Liability

Expenses

Debit+

Credit-

Liability

Debit-

Credit+

Accrued ExpensesTo record salaries expense during the month.


Apr 15 Salaries Expense 950Cash 950

To pay salaries

SalariesExpense

950

Cash

950

Accrued ExpensesTo adjust salaries expense at the end of the month.


Apr 30 Salaries Expense 950Salaries Payable 950

To accrue salaries expense

SalariesExpense

950

SalariesPayable

950

Accrued ExpensesThe following shows the effect of the adjustment.

Salaries Payable

Apr 30 950

Bal. 950

Salaries ExpenseApr 30 950

Bal. 950

Accrued Revenues

Accrued revenue is revenue that has been earned but cash has not been collected. “On Account”

Accrued RevenueTo accrue revenues at the end of the month.


Apr 30 Accounts Receivable 250Service Revenue 250

To accrue service revenue

AccountsReceivable

250

Service Revenue

250

Accrued RevenueThe following shows the effect of the adjustment.

ServiceRevenue

Apr 30 250

Bal. 7,250

Accounts Receivable

2,250

Bal. 2,500

Apr 30 250

7,000

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


Closing the Books

Adjusted Trial Balance

Stockholders’ Equity Accounts

Expanded Accounting Equation

Assets

Liabilities

Stockholders’Equity

Common Stock

+RetainedEarnings

-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 EntriesApr 30 Service Revenue 7,400

Retained Earnings 7,400Apr 30 Retained Earnings 4,415

Rent Expense 1,000Salary Expense 1,900Supplies Expense 300Depreciation Expense 275Utilities Expense 400Income Tax Expense 540

Apr 30 Retained Earnings 3,200Dividends 3,200

Closing AccountsRetained Earnings after closing entries:

Retained EarningsBeg. Bal 11,250

Revenues 7,400Expenses 4,415Dividends 3,200

End Bal 11,035

ACG 2021Financial 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 assetsLong-term assetsCurrent liabilitiesLong-term liabilities

Balance Sheet – Account Format

Balance Sheet – Report Format

Income Statement – Single Step

Income Statement – Multi Step

ACG 2021Financial Accounting

Accounting Ratios

Accounting Ratios

Current RatioTotal Current Assets

Total Current Liabilities=

Debt RatioTotal 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 DebtAbility of a company to pay liabilitiesLower ratio is safer then higher

Why?

End of Chapter 3

Documents

ACG2021 Financial Accounting Chapter 3 Using Accrual Accounting to Measure Income