Accrual Accounting vs. Cash-Basis Accounting

1. Accrual Accounting vs. Cash-Basis Accounting • Two alternative methods may be used for calculating a business’s net income: • Accrual Basis of Accounting • Cash Basis of Accounting • Cash Basis of Accounting • Revenues are recorded when cash is received • Expenses are recorded when cash is paid • No notion of Accounts Receivable (A/R) or Accounts Payable (A/P) • Not a GAAP method

2. Accrual Accounting vs. Cash-Basis Accounting • Two alternative methods may be used for calculating a business’s net income: • Accrual Basis of Accounting • Cash Basis of Accounting • Accrual Basis of Accounting • Revenues are recorded when they are earned – i.e., when the service is performed or the goods are delivered • Expenses are recorded when resources are utilized to use revenue – i.e., when used or consumed • GAAP Method

3. Accrual Accounting Concepts Revenue Principle – governs that revenue should be recognized when it is earned (i.e., when performance has occurred). Matching Principle – governs the recognition of expenses (i.e., that expenses should be recognized when they are incurred). Time-Period Concept (Periodicity) – governs the reporting of accounting information and/or financial statements at regular intervals.

4. Adjustment Process • The calculation of Net Income (Revenues – Expenses) at the end of a period is critical. • Accountants make certain adjustments at the end of the period in order to update records and accurately reflect all revenues and expenses. • The adjustment process involves recording all revenues and expenses that have been earned or incurred in the current period.

5. Rules of Thumb on Adjusting Entries • Each adjusting entry will affect one Revenue or Expense account and one Asset or Liability account. • The key to figuring out the necessary adjusting entries is to: • (1) Identify the revenue/expense that needs to be updated or asset/liability • (2) Identify the corresponding account affected by the transaction. • Adjusting entries never affect cash.

6. Adjusting Entries – Deferrals • Deferrals are when cash has been received or paid in advance of actually recognizing an expense or revenue. • Supplies (Asset) = purchased $500 worth of office supplies. • Prepaid Insurance (Asset) = paid $10,000 for a 6-month insurance premium. • Prepaid Rent (Asset) = paid $10,000 for 1 year of rent. • Unearned Revenue (Liability)= received $2,000 to paint two houses in the future.

7. Deferrals – Initial Journal Entry • Since cash has been received or paid in advance, it may be helpful to think of the original journal entry. This is not required unless the problem specifies it, but can be a helpful first step. Supplies 500 Cash 500 Prepaid Insurance/Prepaid Rent 10,000 Cash 10,000 Cash 2,000 Unearned Revenue 2,000

8. Prepaid Rent Cash 10,000 10,000 Adjustments – Deferrals • Example of the adjustment process for Prepaid Expenses (deferrals) – Prepaid Rent, Prepaid Insurance, and Supplies • These are expenses recorded in advance, in an asset account. • Must properly allocate the expenses to the period during the adjustment process. Example: On December 1, 2005, Shilling Construction, Inc. pre-pays 12 months of rent expense in the amount of $10,000.

9. Adjustments – Deferrals • What is the adjusting entry on December 31, 2005 to record the proper amount of Rent Expense for the period?

10. Adjustments – Deferrals • Example of the adjustment process for Unearned Revenue, in which Revenues (Cash) are received before they are earned. Unearned Revenue is a liability account. Example: On December 1, 2005, Georgetown Painters received $2,000 to paint two houses. At the time of receiving the cash, Georgetown planned to perform the work in the future. Unearned Revenue Cash 2,000 2,000

11. Adjustments – Deferrals • As of December 31, 2005, Georgetown had painted 1 of the two houses. • What is the adjusting entry on December 31, 2005 to record the proper amount of revenue for the month?

12. Adjustments – Depreciation • Depreciation is the allocation of the cost of a plant asset to expense over the plant’s useful life. • Long-lived plant assets (buildings, equipment, etc.) are not expensed when purchased; rather, such assets are expensed as they are used or consumed. • Depreciation expense is recorded in each accounting period in which the asset is used.

13. Adjusting Entry – Depreciation Expense • Calculating depreciation expense: • Using the straight-line depreciation method, allocate an equal amount each accounting period in which the asset is expected to benefit (the “useful life”). • Land is never depreciated. • Depreciation expense = Cost of the Asset Useful Life

14. Adjusting Entry – Depreciation Expense • Accumulated Depreciation • The cumulative total of all depreciation expense relating to a particular plant asset. • It is a “contra asset.” This means it is an “anti-asset,” meaning it is presented with a companion asset account, but it has a normal balance that is opposite the companion account. • Accumulated Depreciation has a credit balance and increases with a credit. • Book Value • Asset – Accumulated Depreciation = Book Value

15. Furniture Accounts Payable 20,000 20,000 Adjustments – Depreciation • Example of the adjustment process for depreciation: On December 1, 2005, Shilling Construction purchases new office furniture on account for $20,000. The furniture is expected to last 5 years.

16. Adjustments – Depreciation • Depreciation Expense = Cost of the Asset Useful Life • Depreciation Expense=$20,000=$4,000/year 5 years • Depreciation Expense=$4,000/yr=$333/month 12 months

17. Adjustments – Depreciation • What is the adjusting entry on December 31, 2005 to record the proper amount of Depreciation Expense for the period?

18. Adjustments – Depreciation • Book Value (or carrying amount) is the net amount of the plant asset, calculated by netting the cost of the asset minus the related accumulated depreciation. • Book value is not the same as fair market value. • Book value represents the amount left to be allocated to depreciation expense in future periods.

19. Adjusting Entry – Accrued Expenses • Accrued Expenses are expenses that have not yet been paid in cash, and have not been recorded at the end of the month. Since cash has not been received or paid prior to recognizing a revenue or expense, this is a type of accrual. • Salary Expense – employees work, but have not yet been paid. • Interest Expense – accrue interest on a bank loan that you borrow, but have not paid the interest back yet. • Interest Revenue – earn interest on a CD, but have not received the cash yet. • Service Revenue – perform ongoing travel services to another corporation.

20. Adjustments – Accrued Expenses • Example of the adjustment process for Accrued Expenses, which are liabilities that arise from expenses that have not yet been paid. Example: Shilling Construction 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 a weekend, Shilling pays the employee on the following Monday. Note: For these purposes, assume that December 31st, the second payday of the month, falls on a Saturday, and so the second half-month amount of $950 will be paid on Monday, January 2nd. Therefore, an adjustment entry is needed on 12/31 for additional salary expense and salary payable.

21. Salary Expense Cash 12/15 950 12/15 950 12/31 950 Bal. 1,900 Salary Payable 12/31 950 Bal. 950 Adjustments – Accrued Expenses

22. Adjustments – Accrued Revenues Example of the adjustment process for Accrued Revenues, which are revenues that have been earned but not yet paid in cash. Example: Towne East hires Air & Sea Travel on April 15th to provide travel services on a monthly basis. Towne East will pay Air & Sea Travel $500 monthly, with the first payment on May 15th.

23. Adjustments – Accrued Revenues • Adjusting Entry:

24. Summary of Adjusting Entries • Adjusting entries always affect at least one: • One Revenue or Expense account – which measure net income • One Asset or Liability account – which update the Balance Sheet • Adjusting entries never involve cash.

25. Adjusted Trial Balance • The Adjusted Trial Balance is a list of all of the ledger accounts (i.e., all of the T-accounts) with their adjusted balances. • The Adjusted Trial Balance is used to prepare the financial statements. Trial Balance Adjustments Adjusted Trial Balance Debit Credit Debit Credit Debit Credit Refer to Exhibit 3-9, page 123, for format.

26. Preparation of Financial Statements • Using the Adjusted Trial Balance, the financial statements must be prepared in the following order: (1) Income Statement • Single step – All Revenues, followed by all Expenses • Multi-step – Subtotals (such as COGS and Gross Profit) (2) Statement of Retained Earnings (3) Balance Sheet • Assets – Current Assets first (in order to liquidity), followed by Long-Term Assets • Liabilities – Current Liabilities, then Long-Term Liabilities • Note: theStatement of Cash Flows does not need to be prepared in a particular order, but it is typically prepared last.