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Accrual Accounting and the Financial Statements – Chapter 3

Accrual Accounting and the Financial Statements – Chapter 3. Accrual Accounting - records the impact of a business event as it occurs VERSUS Cash Basis – records only transactions in which cash is received or paid. The Time-Period Concept.

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Accrual Accounting and the Financial Statements – Chapter 3

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  1. Accrual Accounting and the Financial Statements – Chapter 3 • Accrual Accounting - records the impact of a business event as it occurs • VERSUS • Cash Basis – records only transactions in which cash is received or paid

  2. The Time-Period Concept Financial statements are prepared for specific periods and at regular intervals.

  3. Revenue Principle • Revenue is recorded when it is earned. • The amount of revenue to record is the cash value of goods transferred to customer.

  4. The Matching Principle • Record all expenses incurred during the accounting period • Match expenses against revenues earned

  5. Learning Objective 3 Update the financial statements by adjusting the accounts.

  6. Air & Sea Unadjusted Trial Balance April 30, 20x3

  7. Categories of Accounting Adjustments • Deferrals • Depreciation • Accruals

  8. Prepaid Rent Cash 3,000 3,000 Prepaid Expenses: Rent On April 1, 20x3, Air & Sea Travel prepays three months office rent.

  9. Prepaid Expenses: Rent What is the adjusting entry on April 30? April 30 Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense ($3,000 x 1/3)

  10. Supplies Cash 700 700 Prepaid Expenses: Supplies On April 2, 20x3, Air & Sea Travel paid cash of $700 for office supplies.

  11. Supplies Supplies Expense 4/2 700 4/30 300 4/30 300 Bal. 300 Bal. 400 Prepaid Expenses: Supplies An inventory at month end indicated that $400 in office supplies remained.

  12. Depreciation • Allocation of the cost of a plant asset to expense over the asset’s useful life

  13. Furniture Accounts Payable 16,500 16,500 Depreciation of Plant Assets On April 3, the business purchased furniture on account for $16,500. The furniture is expected to last 5 years.

  14. 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

  15. Depreciation of Plant Assets What is the adjusting entry on April 30? April 30 Depreciation Expense, Furniture 275 Accumulated Depreciation, Furniture 275 To record depreciation

  16. Book Value The net amount of a plant asset (cost minus accumulated depreciation)

  17. 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.

  18. Accrued Expenses Salary Expense Cash 4/15 950 4/15 950 4/30 950 Bal. 1,900 Salary Payable 4/30 950 Bal. 950

  19. 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.

  20. Accrued Revenues Adjusting entry: April 30 Accounts Receivable 250 Service Revenue 250 To accrue service revenue

  21. 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.

  22. Unearned Revenues April 20 Cash 450 Unearned Revenue 450 Received advanced payment April 30 Unearned Revenue 150 Revenue 150 To record revenue earned ($450 x 1/3)

  23. Step 1 Prepare Unadjusted Trial Balance Step 2 Plan Adjustments Step 2 Prepare Adjusted Trial Balance

  24. *Transactions are entered. *End of period adjustments are made. *Prepare the financial statements.

  25. Air & Sea Travel, Inc.Income StatementMonth Ended April 30, 20x5 • Revenue: • Service revenue $7,400 • Expenses: • Salary expense $1,900 • Rent expense 1,000 • Utilities expense 400 • Supplies expense 300 • Depreciation expense 275 3,875 • Income before tax $3,525 • Income tax expense 540 • Net income $2,985

  26. Air & Sea Travel, Inc.Statement of Retained EarningsMonth Ended April 30, 20x5 Retained earnings, April 1, 20x5 $11,250 Add: Net income 2,958 $14,235 Less: Dividends ( 3,200) Retained earnings, April 30, 20x5 $11,035

  27. Air & Sea Travel, Inc.Balance SheetApril 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 stockholders’ equity $31,031 Total liabilities and stockholders’ equity $45,925

  28. Closing Entries • Prepare the accounts for the next period’s transactions. • Transfer the revenue, expense, and dividends balances to Retained Earnings. • Their balances are “zeroed out” so they are ready to accumulate again in the next period.

  29. Which AccountsNeed To Be Closed? • Temporary accounts are closed • Revenue • Expense • Dividends • Permanent accounts are not closed • Assets • Liabilities • Stockholders’ equity

  30. Journalizing the Closing Entries April 30 Service Revenue 7,400 Retained Earnings 7,400 April 30 Retained Earnings 4,415 Rent Expense 1,000 Salary Expense 1,900 Supplies Expense 300 Depreciation Expense 275 Utilities Expense 400 Income Tax Expense 540 April 30 Retained Earnings 3,200 Dividends 3,200

  31. Rent Expense 1,000 1,000 Salary Expense 950 950 1,900 1,900 Dividends Other Expenses 3,200 3,200 1,515 1,515 Posting the Closing Entries Service Revenue 7,400 7,000 250 150 7,400 Retained Earnings 4,415 3,200 11,250 7,400 11,035

  32. Classifying Assets and Liabilities • List assets and liabilities in order of their relative liquidity. • Liquidity - how quickly an item can be converted to cash.

  33. Classifying Assets and Liabilities Current assets Long-term assets Current liabilities Long-term liabilities

  34. Use the current ratio and the debt ratio to evaluate a business.

  35. 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

  36. 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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