ch3 for myself v2 accounting

8/12/2019 Ch3 for Myself v2 Accounting

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1

On July 9, 2010, ABC Company provides legal service toa client, who agrees to pay $200 within one month.On Aug 3, ABC Company receives a check of $200from this client.

When should you record revenue on the book?

Your company opens an electricity account with AmigoEnergy which starts to supply energy on July 1, 2010.On August 4, you receive an electricity bill of $100 forthe period July 1- 31.

Does this expense belong to the month of July or August?


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Accrual Accounting and Income

Chapter 3

2

1. Accrual accounting

Revenue principle

Matching principle

Time period concept

2. Adjusting entries

Deferrals, accruals, depreciation

3. Closing the book

4. Current and long-term assets (liabilities)

5. Current ratio and Debt ratio

6. How to construct a simple Cash Flow

statement using indirect method.


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ACCRUAL ACCOUNTING

Records impact of transactions when they occur

Records:Revenue when earned (e.g., sales on account)

Expenses when incurred (e.g., purchase on account)

No matter whether cash has been received or paid

3

Which method

provides more

information?

In contrast, cash accounting recordstransactions when and only when cashpayment or receipt is involved.


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Some of the transactions recorded in accrual

accounting:

4

Cash transactions Noncash transactions

Collecting payments from

customers

Sales on account

Borrowing money Depreciationexpense

Paying expenses Purchases on account

Paying off loans Usage of prepaid expenses

Issuing stock Accrual of expenses not yet

paid

Accrual accounting is morecomplex but also more

completeand more

informative.


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Time Period Concept

Accounting information is reported at regular intervals--Year, quarter, month

All businesses prepare annual financial statements

The financial year (fiscal year) could be a calendar year or

any other one year period (e.g. April 1 to March 31)

In addition to annual reports, many companies produce

interim financial reportsas well (e.g. quarterly reports)

5


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Revenue Principle

6

When to record

After revenueis earned:

When good orservice hasbeendelivered tocustomer

Amount to record

Cash valueofgoods orservicestransferred tocustomer


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Matching Principle--

align revenue with expenses

7

Expenses are matched against the revenue that

was earned in a particular period

Expenses incurred to generate revenues should be

recorded in the same period.

When revenues and expenses are properlymatched, we get a reliable measure of net income

(or net loss)

Some expenses are paid in cash

Others are not yet paid for (accruals) Certain other expenses arise from using up assets

(e.g. supplies)


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The Adjusting Process

Adjusting entries are at the heart of accrual accounting.

Accrue- to accumulate a receivable or payable during a givenperiod even though no explicit cash transaction occurs

The receivable or payable grows with time, but nothingchanges with cash.

The goal of adjusting entries is to assure that assets, liabilities,and stockholders equity are properly stated.

Adjusting process is usually made when the financialstatements are about to be prepared.

They are made in the form of adjusting journal entriesthat are posted to the T account.

2010 Pearson Prentice Hall. All rightsreserved.

1-10


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Categories of Adjustments

11

Deferrals Depreciation

Accruals

Lets do some necessary adjustments!


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1-12

Prepaid Expenses

Unearned Revenue

Depreciation

Accrued Expenses

Accrued Revenue

Five Types of Adjustments


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Deferrals

Business has paid or received cash in advance

13

Prepaid expense

Recorded as an asset when

purchased Expensed when used or

expired

Unearned revenue

Recorded as a liability whenpayment is received

Recorded as revenue whenearned


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How to record these transactions initially?

June 1: pay $12,000 rent for 1 year from this June

to next June.

Aug 3: purchase $3,500 supplies that can last foryears

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JOURNAL

Date Accounts and explanation Debit Credit

June 1 Prepaid rent 12,000

Cash 12,000

Aug 3 Supplies 3,500

Cash 3,500

Do we have the same amount of

prepaid rent and assets by the year

end?


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Use T-accounts to analyze the balances and prepare the

adjusted journal entries:

First: decide what ending balances should appear in the

asset (Prepaid Rent) and expense (Rent Expense)

accounts.

In this example, 7 months expense had been used,therefore $7,000 should be shown in Rent Expense

($1,2000/12 months x 7 months).

Also, at December 31, there are still 5 months remaining

(unused), and $5,000 should be shown in Prepaid

Rent.


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Lets look at the T-accounts

16

Prepaid rent

June 1 $12,000 Dec 31$7,000

$5,000

Rent expense

$7,000Dec 31

Balance

Sheet

Income

Statement

ASSET


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Adjustments made at year end:

Aug 3rd, purchase 3,500 supplies.

On Dec 31th, $600 supplies at hand.

Supplies are expensed when they are used

17

JOURNAL


Dec 31 Rent expense 7,000

Prepaid rent 7,000

Dec 31 Supplies expense 2,900

Supplies 2,900


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18

SuppliesAug 3 $3,500 Dec 31$2,900

$600

Supplies expense$2,900Dec 31

Amount usedAmount on hand

Balance

Sheet

Income

Statement

ASSET


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Question

On January 1, Bambi Company paid $1,200 rent to cover six

months, the adjusting entry at the end of January should include


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1. A credit to Prepaid

Rent for $1,000

2. A credit to PrepaidRent for $200

3. A debit to Prepaid

Rent for $1,0004. A debit to Prepaid

Rent for $200


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Question

Garcia Company purchased a one-year insurance policy on April 1, Year 1, for $6,000.

After year-end adjustments, the amount of prepaid insurance and the amount of

insurance expense at December 31, Year 1, are, respectively


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1. $1,500, $4,500.

2. $4500, $1,500.

3. $2,000, $4,000.

4. $4,000, $2,000.


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What happens to receipt in advance?

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JOURNAL


Sept 1 Cash 12,000

Unearned service revenue 12,000

Receive client payment in advance

No free lunch in the world with

money accepted now you have an

obligationto deliver service in the

future.

Sept 1: you receive $12,000 cash from client for legalservice of next 12 months. $1,000 per month.

A dj t t t th d f th EARNED


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Use T-accounts to analyze the balances and prepare the

adjusting entry:First: decide what ending balances should appear in

the liability (Unearned Service Revenue) and revenue

(Service Revenue) accounts.

In this example, 4 months revenue had been earned

by 12/31, therefore $4,000 should be shown in Service

Revenue ($12,000/12 months x 4 months).

Also, at December 31, there are still 8 monthsremaining (unearned), and $8,000 should be shown in

Unearned Service Revenue.

Any adjustment at the year end for the EARNEDportion?


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23

Unearned Service Revenue

June 1$12,000Dec 31 $4,000

$8,000

Service Revenue

$4,000 Dec 31

Balance

Sheet

Income

Statement

LIABILITY


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Adjusting Entry at the year end:

24

JOURNAL

Date Accounts and explanation Debit CreditSept 1 Cash 12,000

Unearned service revenue 12,000

Receive client payment in advance

Dec 31 Unearned service revenue 4,000

Service revenue 4,000

How do these adjustments

affect balance sheet andincome statement?


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Question

On October 1, River Place Apartment received $5,200 from a tenant

for four months rent. The Receipt was credited to Unearned Rent

Revenue. What adjusting entry is needed on Dec 31th?


1-25

A. Unearned Rent Revenue 1,300

Rent Revenue 1,300

B. Cash 1,300Rent Revenue 1,300

C. Rent Revenue 1,300

Unearned Rent Revenue 1,300

D. Unearned Rent Revenue 3,900

Rent Revenue 3,900


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Question

Rodenko, Inc., publishes a monthly sports magazine. On July 1, Year 1, the company sold

1,000 two-year subscriptions for $100 each. On December 31, Year 1, the amount

reported as a liability on the balance sheet and the amount reported as revenue on theincome statement are, respectively


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1. $0, $100,000.2. $25,000, $75,000.

3. $50,000, $50,000.

4. $75,000, $25,000.


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Depreciation

How to record a transaction like this?

Jan 1: purchase a machine with $50,000 cash, which is

expected to be used for five years

Do we have the same amount of asset at year end? How

to adjust?

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JOURNALAccounts and explanation Debit Credit

Equipment 50,000

Cash 50,000

i i


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Depreciation

Allocates cost of plant assets to expense over useful lives

Represents wear-and-tear and obsolescence

Examples of plant assets:

Buildings

Equipment

Furniture With depreciation, a new account,

Accumulated Depreciation, is introduced.

Accumulated depreciation - the cumulative sum of all

depreciation recognized over the life of a particular asset.

Straight-Line Depreciation Expense =

28

Useful Life

Asset Cost

D i i


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Depreciation

29

Equipment

Jan 2

$50,000Depreciation Expense

$10,000Dec 31

Both numbers

enter the Balance

Sheet Income

Statement

Accumulated Depreciation

Dec 31$10,000

Depreciation on Dec 31

One year depreciation =

50,000 / 5 = 10,000


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Depreciationinitial and adjusting journal entries

30

JOURNAL


Jan 2 Equipment 50,000

Cash 50,000

Dec 31 Depreciation expense 10,000

Accumulated depreciation 10,000

A contra asset

account

Q: without the year-end adjustment,

do we get a complete picture aboutthis asset?

M b t A l t d D i ti


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More about Accumulated Depreciation

Sum of all depreciation expenses

Increases over plant assets life Contra-asset: a separate but related account that

offsets or is a deduction from a companion account.

Normal credit balance

Always has a companion account

Appear on Balance Sheet along with certain assets

Book value of plant asset

= Cost of plant asset - accumulated depreciation

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Book value is also

called carrying value.


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Question

What is the effect on the financial statements of recording

depreciation on equipment?


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1. Net income is not affected, but

assets and stockholders equity

are decreased.

2. Net income and assets are

decreased, but stockholdersequity is not affected.

3. Net income, assets, and

stockholders equity are all

decreased.4. Assets are decreased, but net

income and stockholders

equity are not affected.

A l


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Accruals

Accrued expenses

Record expense

before paying cash Salaries, interest,

and income taxes

Accrued revenues

Record revenue

before collectingcash

Earned and willcollect next period

34

No cash has changed hands yet, but youve

owed or earned something:

A d S l i


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Accrued Salaries

35

12-30 12-31 1-31-21-1

$15,000 weekly salaries

$6,000 $9,000

How to present this picture at 12/31?

Costs incurred in a period, that are both unpaid and unrecorded.

Match the expenses to the periods revenues!

Accrued expenses are recorded for amounts that are owedat the end of

an accounting period but have not been paid in that accounting period.In the accrual accounting, a liability(salary payable) is recorded and

increased (Credit).

A d S l i


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Accrued Salaries

36

JOURNAL


Dec 31 Salaries expense 6,000

Salaries payable 6,000

Later:

JOURNAL


Jan 3 Salaries payable 6,000

Salaries expenses 9,000

Cash 15,000


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Interest is much like rent paid for the use of borrowed

money.Interest accumulates (accrues) as time goes on, regardless

of when the interest is actually paid.

Interest = Principal x Interest rate x Fraction of a year

The entry to record the accrual of interest expense is very

similar to the entry to record the accrual of wage expense.

Accrued Interest

JOURNAL


Dec 31 Interest expense xxxxInterest payable xxxx


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2010 Pearson Prentice Hall. All rightsreserved. 1-38

Accrued Income Tax

As income is generated, income tax expense is accrued rather

than paid by the company each time a dollar comes in.

The entry to record accrued income taxes is similar to the

accrual of other expenses.

JOURNAL


Dec 31 Income Tax Expense xxxxIncome Tax Payable xxxx

Accrued Revenue


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Accrued Revenue Revenue earned but not yet received

The adjusting entries show the recognition of revenues that have been earned,but the entity has not received cash.

Increases receivables and revenue

39

JOURNAL


Dec 31 Accounts receivable 1,500

Service revenue 1,500

Accrued Revenue

Later:

JOURNAL

Date Accounts and explanation Debit CreditJan 5 Cash 1,500

Accounts receivable 1,500

Collect cash from customer

How accrued revenue is different from

unearned revenue?


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Question

If a real estate company fails to accrue commission revenue,


1. Revenue are understated

and net income is overstate.

2. Assets are understated and

net income is understated.

3. Net income is understated

and stockholders equity is

overstated.

4. Liabilities are overstated

and owners equity isunderstated.

Prepaids and Accruals a summary


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Prepaids and Accrualsa summary

Deferral CASH FIRST

FIRST LATER

Prepaidexpenses

Prepaid expense (Assets) Expense

Cash Prepaid expense

Unearned

revenues

Cash Unearned revenue

Unearned revenue (Liability) RevenueACCRUALS CASH LATER

FIRST LATER

Accruedexpenses

Expense Accounts Payable

Accounts Payable Cash

Accruedrevenues

Accounts Receivable Cash

Revenue Accounts Receivable

41

S f th Adj ti P


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Summary of the Adjusting Process

Two purposes

Measure income

Update balance sheet

Every adjusting entry affects at least one:

Revenue or expense

Asset or liability

42

Exercise: Journalize adjusting entries on Dec 31 for each


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Exercise: Journalize adjusting entries on Dec 31 for each

situation

a. The business has interest expense of $9,500 incurred

during 2010 that it must pay early in January 2011.

1-43

b. Interest revenue of $4,500 has been earnedbut notyet received.

JOURNAL


(a) Interest expense 9,500

Interest payable 9,500

(b) Interest receivable 4,500

Interest revenue 4,500

Exercise : journal entries of Dec 31


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Exercise : journal entries of Dec 31

44

(c) Unearned rent revenue 3,400

Rent revenue 3,400

c. On July 1, when we collected $13,600 rent in advance,

we debited Cash and credited Unearned Rent

Revenue. The tenant was paying us for 2 years rent.

d. Salary expense is $1,800 per dayMonday throughFridayand the business pays employees each Friday.

This year, December 31 falls on a Wednesday.

(d) Salary expense 5,400

Salary payable 5,400

As the Exercise continues:


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As the Exercise continues:

e. The unadjusted balance of the Supplies account is

$3,300. The total cost of supplies on hand is $1,200.

1-45

f. Equipment was purchased at the beginning of this

year at a cost of $100,000. The equipments useful

life is 5 years.

(e) Supplies expense 2,100

Supplies 2,100

(f) Depreciation expense 20,000

Accumulated depreciation 20,000

Exercise:


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46

Balance SheetDecember 31, 2010

Equipment $100,000

Less: AccumulatedDepreciation

(20,000)

Book value $80,000

Exercise:

The Adjusted Trial Balance


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The Adjusted Trial Balance

Prepared after adjustments are journalized and

posted

Useful step in preparing financial statements

47

ExerciseShineBrite Cash Wash Company


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p y

Preparation of Adjusted Trial Balance

Dec 31th, 2010


Unadjusted

Debit Credit

Cash 10

Accounts Receivable 12

Supplies 24

Accounts Payable 12

Unearned Revenues 22

Common Stock 6

Retained Earnings 2

Dividends 4

Service Revenues 14

Salaries Expense 6

Supplies Expense 0

56 56

Adjusting JE

Debit Credit

8

6

6

8

Adjusted

Debit Credit

10

12

16

12

16

6

2

4

20

6

8

56 56

ExerciseShineBrite Cash Wash Company


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(a) A physical count made at the end of the period

revealed that there were supplies on hand with a cost of

$16.

AJE:

(b) The unearned revenues account shows $16 had still not

been earned as of year-end.

AJE:


Preparation of Adjusted Trial Balance

Dec 31th, 2010

(a) Supplies expenses 8

Supplies 8

(b) Unearned Revenue 6

Service Revenue 6


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Closing the books


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Closing the books

Prepared after the financial statements have beenprepared.

Prepares the accounts for next period

Temporary accounts are set to zero and closed intoRetained earnings

Can you guess what are the temporary accounts?

51


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Temporary accounts

Revenues

expenses

dividends

52

Note: the post-closing Trial Balance consists only of balancesheet accounts.All of the temporary accounts have beenclosed to Retained Earnings, and we are now ready to start

a new year, and accumulate new balances for revenues,expenses, and dividends.


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P3-75A


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P3 75A

Spa View Service, Inc., with fiscal year end March 31, has

following accounts balance:

Service revenue: 95,000

Dividends: 31,200

Advertising expense: 10,900

Depreciation expense: 1,700 Interest expense: 900

Salary expense: 17,800

Supplies expense: 4,400

How to close the accounts? How does retained earnings change?

1-54

P3-75Ajournal entries to close revenue and


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55

JOURNAL


3/31 Sales revenue 95,000

Retained earnings 95,000

jexpenses accounts

3/31 Retained earnings 35,700

Advertising expense 10,900

Depreciation expense 1,700

Interest expense 900Salary expense 17,800

Supplies expense 4,400

P3 75A journal entries to close Dividends


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56

JOURNAL


Retained earnings 31,200

Dividends 31,200

P3-75Ajournal entries to close Dividends

Changes to Retained Earnings


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Changes to Retained Earnings

57

Retained Earnings

$22,000BeginningBalance

$95,000 Revenues$31,200

$35,700

Dividends

Expenses

$50,100EndingBalance


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Question

A major purpose of preparing closing entries is to


A. Zero out the liability

accounts

B. Close out the supplies

account

C. Adjust the asset accounts

to their correct current

balances

D. Update the RetainedEarnings account.

Question


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Question

Which of the following accounts would notbe included in the closing

entries?


A. Depreciation Expense

B. Retained Earnings

C. AccumulatedDepreciation

D. Service Revenue

Current or Long-term


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Current or Long term

Current assets:Cash

Short-term investments

Accounts receivable

Merchandise inventory

Prepaid expenses are the current assets

Assets are classified as current or long-term term based on liquidity,or how quickly an item can be converted to cash.

60

Can be turned intocash within one year or

one operating cycle.

Current Liabilities


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Current Liabilities

Debts that must be paid within 1 year or within the entitys

operating cycle if longer than a year:

Accounts payable

Notes payable due within 1 year

Salary payable

Unearned revenue

Interest payable

Income tax payable

61


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Converted to cash, sold or

consumed in the next year

Current

assets

Held for longer than one year

Includes plant assets

Long-termassets

Must be paid within one yearCurrentliabilities

Due date more than one yearfrom balance sheet date

Long-term

liabilities

Classified Balance Sheet


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Categorizes and subtotals assets and liabilities

63

Assets Liabilities

Current assets Current liabilities

Long-term investments Long-term liabilitiesProperty, plant and equipment

Other assets

Financial Statement Formats


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Balance Sheet

Report Format

Assets listed at the top

Liabilities and equity beneath

Account format

Assets on the left Liabilities and equity on the right

Income Statement

Single-Step

All revenues grouped together

All expenses grouped together

Multi-step

Shows subtotals to emphasize

relationships

Includes

Gross profit

Income from operations

64

Use two new ratios to evaluate a business


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65

Current Ratio Debt Ratio

Enhance users ability to analyze

companys past performance

From the names, how do you think the

ratios should be computed?

And what do they tell you?

Current Ratio


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66

Current assets

Current liabilities

It measures ability of a business to pay current liabilitieswith its current assets

Whats the implication if this current ratio is less than one?

As a rule of thumb, a strong current ratio is 1.50Most successful businesses operate with current ratiosbetween 1.20 and 1.50

Debt Ratio


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Total assets

Total liabilities

Measuresthe proportion of a businesssassets that are financed with debt.

Measures businesss ability to pay both

current and long-term debt

Low debt ratio is safer than high debt ratio, thoughnot necessarily better.

Question


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Question

UPS earns service revenue of $800,000. How does this transaction

affect UPS ratio?


A. Improves the currentratio and does not affect

the debt ratio

B. Hurts the current ratio

and improves the debt

ratio

C. Hurts both ratio

D. Improves both ratios

Question


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Question

Suppose Green Mountain Corporation borrows $20 million on a 20

year note payable. How does this transaction affect its ratios?


A. Hurts both ratio

B. Improves both ratios

C. Improves the current

ratio and hurts thedebt ratio

D. Hurts the current ratio

and improves the debt

ratio


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71

Statement of Cash FlowsFor the year ended December 31, 2010

Cash flows from operating activities 60

Cash flows from investing activities 20

Cash flows from financing activities (30)

Net cash flows 50

Cash balance, December 31, 2009 10

Cash balance, December 31, 2010 60

How to prepare a cash flow statement


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How to prepare a cash flow statement

Part 1- Cash Flow from Operations*

Net Income

+ Depreciation expense

Increases in accounts receivable

+ Decreases in accounts receivable + Increases in accounts payable

Decreases in accounts payable

= Cash flows from operating activities*The above is a simple version.


Cash Flow from Operations


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Add back Depreciation

Depreciation is a non-cash expense thatreduces net income. Therefore, it is added

back to put net income on a cash basis.



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Decrease in accounts receivable

The reverse is true for a decrease in accountsreceivable.

A collection of accounts receivable provides

cash but does not affect net income.

Therefore, the decrease in this current asset is

an addition to put net income on a cash basis.


Cash Flow from Operations-


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Increase in accounts payable

Consider accounts payable. An increase inaccounts payable decreases net income

because of the associated expense.

However, since no cash is yet paid, theincrease in this current liability is shown as an

addition to put net income on a cash basis.

1-76

Cash Flow from Operations -


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Decrease in accounts payable

The reverse is true for a decrease in accountspayable. A payment of accounts payable uses

cash but does not affect net income.

Therefore, the decrease in this currentliability is a subtraction to put net income on a

cash basis.



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Example- Indirect method - Cash FlowsItem Amount

Net Profit $269

Depreciation, Amortization $188

Increase in accounts receivable ($179)

Increase in notes receivable ($84)

Increase in Accounts payable $89

Net Cash provided byoperations

$ 283

1-78


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h l f


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Cash Flow from Investing

Investing activities include cash from buyingand selling noncurrent assets.

It also includes cash generated (lost) from

investments in securities.

2010 Pearson Prentice Hall. All rights

reserved. 1-80

C h l f i i i i i


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Cash Flow from Financing Activities

Financing activities include

borrowing and repaying money,

distributing dividends and

issuing stock.

2010 Pearson Prentice Hall. All rights

reserved. 1-81

SUMMARY


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82

Compare accrual and cash basis accounting

Apply the revenue and matching principles

Adjust the accounts

Prepare the financial statements

Close the temporary accounts Use ratios to evaluate a business

Understand how to construct a cashflow

statement using the indirect method

SUMMARY


83/83

Compare accrual and cash basis accounting

Apply the revenue and matching principles

Adjust the accounts

Prepare the financial statements

Close the temporary accounts Use ratios to evaluate a business

Cash Flow

ch3 for myself v2 accounting

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