Accrual Accounting

1. Accrual Accounting By P. Raghava Narayana Chartered Accountant

2. ACCRUAL Records business transactions when they occur When sale is made When bill is received Complies with GAAP Presents accurate financial picture CASH Records transactions only when cash is received or paid When customer pays for product or service When bills are paid Only used by very small businesses Omits important info Accrual vs. Cash-Basis Accounting .

3. Accrual Accounting and Cash Flows • Accrual accounting records both cash and non-cash transactions Cash Collecting from customers Paying for expenses Borrowing money Issuing Shares Non-cash Sales on credit Purchases on credit Using prepaid expenses, such as supplies

4. Businesses do not stop operations to measure financial transactions Accountants prepare financial statements at regular intervals to measure performance Companies select a twelve-month period for reporting purposes: Calendar year Fiscal year Time-Period Concept

5. The Revenue Principle • Revenue is recordedwhen earned • When product or service is delivered to customer • Cash may come before, at the same time, or after delivery • Revenue is recorded at the cash value of goods or services provided

6. The Matching Principle • Expenses are incurred to help produce revenue • Expenses should be recorded in the time period in which they are incurred • Expenses should be matched to the revenues they help produce EXPENSES REVENUES

7. May be paid in cash Paying monthly rent May arise from using up an asset Using supplies previously purchased May arise from creating a liability Receive a bill from a supplier Expenses

8. ILLUSTRATION • During the financial year 2010-11, Ashok had cash sales of Rs. 3,90,000 and credit sales of Rs. 1,60,000. • His expenses for the year were Rs. 2,70,000 out of which Rs. 80,000 is still to be paid. • Find out Ashok's income for 2010-11 following the Cash Basis of Accounting.

9. The Adjustment Process • At the end of the period, a business prepares financial statements • Ensures that: • All revenue that has been earned has been recorded • All expenses that have been incurred are matched to revenues • Asset and liability accounts are up-to-date

10. Categories of Adjusting Entries • Deferrals • Depreciation • Accruals

11. Deferrals Cash has already been received or paid Related expense or revenue has not yet been recorded Prepaid expenses Company has paid for expense in advance Adjustment needed to record amount used Unearned revenues Customer pays in advance for good or service Adjustment needed to record amount of revenue earned

12. Prepaid Expenses • Expenses paid in advance • Include prepaid rent and supplies • Asset is recorded when purchased • Adjustment needed to record amount used

13. Prepaid Rent Example • Suppose on April 1 on a company paid Rs.12,000 for one year’s rent in advance

14. Prepaid Rent Example • Now, it’s December 31 and assume that the company is closing its book on December 31. • The amount of rent that has expired must be recorded • This amount is recorded as rent expense • Prepaid rent (asset) needs to be reduced so it reflects the amount of rent remaining

15. Rs. 12,000 Prepaid Rent Rs.9,000 Rs. 3,000 December 31 April 1, following year April 1, current year April 1 to December 31 = 9 months 3 out of 12 months of rent remains 9 out of 12 months of rent has expired 3/12 x Rs. 12,000 = Rs. 3,000 9/12 x Rs. 12,000 = Rs. 9,000 15

16. Prepaid Rent Example Dec 31 – Adjust Prepaid Rent account for amount expired

17. Prepaid Rent Rent Expense Apr 1 Rs.12,000 Dec 31 Rs.9,000 Dec 31 Rs.9,000 Represents amount expired Rs.3,000 Represents amount remaining End-of-year balance

18. Supplies Example • Suppose a company purchased Rs. 3,200 of supplies during the year • The asset “supplies” was debited for each purchase • At the end of the year, a physical count reveals Rs. 500 of supplies on hand

19. Supplies Example Supplies Rs.3,200 What amount of supplies was used? Balance per ledger Balance per physical count Rs. 500 Subtract the balance per count from the balance per ledger

20. Supplies Example • Dec 31 – Adjust Supplies account for amount used

21. Supplies Supplies Expense Rs.3,200 Dec 31 Rs.2,700 Dec 31 Rs.2,700 Represents amount used Rs.500 Represents amount on hand End-of-year balance

22. Depreciation of Plant Assets • Allocation of plant assets cost over their useful lives • Results in a debit to an expense • Depreciation Expense • Corresponding credit • Accumulated Depreciation

23. Accumulated Depreciation • Account that shows the sum of depreciation expense of the plant asset • Contra-asset • Always has a companion account • Normal credit balance

24. Depreciation Example • A company purchases equipment for Rs. 50,000 • The estimated useful life of the equipment is five years Rs. 5,000 annual depreciation 50,000/5 years =

25. Depreciation Example • Dec 31 – Adjusting entry to record depreciation of equipment

26. Depreciation – Balance Sheet

27. Accrued Expenses • Expense incurred before cash is paid • Result in a liability • Common accrued expenses: • Salaries • Interest • Taxes

28. Accrued Salary Expense Example • A company pays its employees a weekly salary each Friday • Salaries for each week total Rs. 10,000 • December 31, the company’s year-end, falls on a Wednesday

29. Rs.10,000 Salaries Rs6,000 Rs4,000 Friday, January 2 pay day Monday, December 29 Wednesday, December 31 year end Monday through Wednesday = 3 days 3 out of 5 days of salaries expense has been incurred 3/5 x Rs10,000 = Rs6,000

30. Accrued Salary Expense Example • Dec 31 – Record accrued salary expense

31. Accrued Revenues • Companies often earn revenue before cash is received • Results in an accrued revenue • Receivable recorded

32. Accrued Revenue Example • A company performed services for customers during the last week of the year totaling Rs. 5,000 • The revenue has not yet been recorded because the customers won’t be billed until January

33. Accrued Salary Expense Example • Dec 31 – Record accrued revenue

34. Unearned Revenues Recorded as a liability when company receives payment Company owes customer product or service Revenue is not recorded until earned When company provides product or service An adjusting entry is made to transfer amount from unearned revenue to revenue

35. Unearned Revenue Example • On November 1, a company receives a customer payment of Rs. 18,000 for services to be performed during the next three months

36. Unearned Revenue Example • Nov 1 – Record advance payment received by customer

37. Rs.18,000 Rs.12,000 Rs.6,000 December 31 January 31, following year November 1, current year November 1 to December 31 = 2 months 1 out of 3 months remains unearned 2 out of 3 months of revenue has been earned 1/3 x Rs. 18,000 = Rs. 6,000 2/3 x Rs, 18,000 = Rs. 12,000

38. Unearned Revenue Example • Dec 31 – Record portion of unearned revenue that has been earned

39. Unearned Revenue Service Revenue Dec 31 Rs. 12,000 Nov 1 Rs.18,000 Dec 31 Rs.12,000 Represents amount earned Rs.6,000 Represents amount unearned End-of-year balance

40. Summary of Adjusting Entries • Purpose of adjusting entries • Measure income • Update balance sheet • Each adjusting entry affects • One income statement account • Revenue or Expense • One balance sheet account • Asset or liability

41. Adjusted Trial Balance • Trial balance prepared after adjusting entries are made and posted • These amounts are used to prepare the financial statements: • Income Statement – Profit and Loss account • Balance Sheet

42. Income Statement • Reports net income or loss • Revenues minus expenses • Net income flows to Retained Earnings Statement (a.k.a Reserves & Surplus)

43. Statement of Retained Earnings • Shows changes to the Retained Earnings account • Net Income is added to beginning balance • Dividends are subtracted • Ending Retained Earnings flows to the Balance Sheet

44. Balance Sheet • Reports assets, liabilities and equity • Shows that the accounting equation is in balance

45. INCOME STATEMENT NET INCOME RETAINED EARNINGS STATEMENT ENDING RETAINED EARNINGS BALANCE SHEET

46. Closing the Books • Done after financial statements are prepared • Set temporary accounts to zero • Transfers balances to retained earnings account • Journalizes activity in Statement of Retained Earnings

47. Temporary Revenues, Expenses and Dividends Closed Balances represent a period of time Permanent Asset, liability and equity accounts Not closed Ending balance of one period carries over to following period Temporary and Permanent Accounts

48. Closing Entries • Debit each Revenue account for the amount in its credit balance • Retained earnings is credited • Credit each Expense account for the amount in its debit balance • Retained earnings is debited • Credit Dividends for the amount in its debit balance • Retained earnings is debited R E D

49. Dec 31 – Close Revenues

50. Which account would be debited? Total the expenses for the amount • Dec 31 – Close expenses