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Accrual Accounting and Income Notes

I.

Accrual Accounting and Cash Flows


A.

Definitions

B.

Accrual accounting: records the impact of a transaction as it occurs


irrespective of when cash is received or paid; record revenue when
a sale is made, a service is performed; record expense when it is
incurred.
o Required by GAAP
o Includes both cash and noncash transactions
o More representational faithful of economic reality
Cash-basis accounting: records only cash transactions; receipts are
revenues; payments are expenses.
o Ignores noncash events ie., sale on account
o Misstates the balance sheet and income statement; makes
them incomplete
o Users are making decisions based on incomplete data

Accrual Concepts and Principles


1. Time-Period Concept: accounting information is reported at regular
intervals
a. Always for a one year period of time
b. Can by fiscal or calendar year
c. Can be done more frequently monthly, quarterly
2. Revenue Principle: defines when to record revenue and how much
to record
a. When: when it has been earned; when a business has
delivered a good or service to a customer
b. How much: the cash value of the good or service transferred
to the customer
3. Matching Principle: the basis for recording expenses (cost of assets
used up and of liabilities created in the production of revenue)
a. Identify and measure all expenses incurred during the period
b. Match them against the revenues earned from incurrence of
the expense

C.

The Adjustment Process

Some accounts are affected by things other than day-to-day


transactions. The adjustment process means that you must examine your
accounts to determine if they are up-to-date or not; if not, they must be
adjusted.
1.

Categories of Adjusting Entries


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Deferrals: a deferral is an adjustment to an account that


represents something the business paid in advance OR that
represents the receipt of cash in advance

Paid-in-advance: companies buy supplies in advance of use, pay


insurance in
advance of the insurance period covered, pay rent
in advance of the month
covered etc ; these transactions are
recorded as assets at the time the
payment is made
(supplies or prepaid expenses). Now, time has past and some
of the asset has been used in operations or the asset now relates to current
period being reported.
Example: company pays rent in advance (June 1; paid three months rent
$3,000)
Date
June 1 (when paid)

Accounts
Prepaid Rent
Cash
To record prepayment of rent.
June 30 (June
adjustment)

Debit

Credit
3,000
3,000

Rent Expense
1,000

Prepaid Rent
To adjust prepaid rent for June and record rent expense.

Reference
June 1
Total
debits
Balance

Reference
June 30
Total
debits
Balance

1,000

Prepaid Rent
Debit (+)
Credit (-)
Reference
3,000
1,000 June 30
Total
3,000
1,000 Credits
2,000
Rent Expense
Debit (+)
Credit (-)
1,000
1,000
1,000

Reference
Total
0 Credits

Example: Supplies were bought on June 2 nd $700. At month end, $400 of


supplies remain.
Date
June 2 (when paid)

Accounts
Supplies
Cash

Debit

700
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Credit
700

To record purchase of supplies.


June 30 (June
adjustment)

Supply Expense
300

Supplies
To record supplies used in the month of June.

Reference
June 2
Total
debits
Balance

Reference
June 30
Total
debits
Balance

300

Supplies
Debit (+)
Credit (-)
Reference
700
300 June 30
Total
700
300 Credits
400
Supplies Expense
Debit (+)
Credit (-)
300
300
300

Reference
Total
0 Credits

Receipt of cash in advance: the business receives payment for


goods or services
in advance of when delivery occurs; the cash
receipt is recorded as a deferred
liability (we owe the
money back if we do not perform); common examples are
subscription revenue, prepaid cell phone charges; the liability is called
unearned revenue; it is earned when the good is
delivered or the service
performed.
Example: Home Depot hires the company to wash it trucks for $400 a month
and pays for the
first month on June 15th.
Date
June 15 (when paid)

Accounts
Cash
Unearned Service
Revenue
To record purchase of supplies.

Debit

Credit
400

Unearned Service
Revenue
200
Service Revenue
To record service revenue that has now been earned (1/2 month).

400

June 30 (June
adjustment)

Unearned Service Revenue


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200

Reference
June 30
Total
debits

Debit (-)
Credit (+)
Reference
200
400 June 15
Total
200
400 Credits
200 Balance

Service Revenue
Debit (-)
Credit (+)
Reference
200 June 30
Total
Total
debits
0
200 Credits
200 Balance
Depreciation: the allocation of the cost of plant asset to
expense over the assets useful life.
Reference

The adjustment is a debit to depreciation expense (increase


credit to accumulated depreciation (increase

expense) and a
contra-asset).

Example: Company bought car washing equipment on June 2 for $24,000. They
expect the equipment to be used for five years and to have no value at that the end
of its use.
Date
June 2 (when
purchases)

Accounts
Equipment

Debit

Credit
24,000

Cash
To record purchase of equipment
June 30 (June
adjustment)

24,000

Depreciation Expense

400
Accumulated
Depreciation
400
To record depreciation expense for June (24,000/60 months = 400 per month)

Reference
June 2
Total
debits
Balance

Equipment
Debit (+)
Credit (-)
24,000
24,000
24,000

Reference
Total
0 Credits

Accumulated Depreciation - Equipment


Reference
Debit (-)
Credit (+)
Reference
400 June 30
Total
0
400 Total
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debits

Reference
June 30
Total
debits
Balance

Credits
400 Balance
Depreciation Expense
Debit (+)
Credit (-)
400
400
400

Reference
Total
0 Credits

Accumulated depreciation represents the cumulative amount of


depreciation
that has been charged to expense for the
assets reported; it is a contra-asset
account; a contra
account means that the account acts opposite to the
account to which it relates.

Since you debit to increase and credit to decrease an asset, you


debit to
decrease and credit to increase a contraasset (the opposite of an asset).
Notice that the original fixed asset, equipment, is not reduced
for its usage (like
supplies). Since the asset will benefit
multiple periods, we leave its original cost
recorded in the
asset account and track the cumulate amount that has been
used in accumulated depreciation.
The difference between the original cost of the asset and the
accumulated
depreciation represents the unexpired or
unexpensed cost of the asset; this is
called net book value.
Equipment at cost
24,000
Less: Accumulated depreciation, equipment
400
Net book value of equipment
23,600
At the end of July, the net book value would be:
Equipment at cost
24,000
Less: Accumulated depreciation, equipment
800
Net book value of equipment
23,200

Accruals: an accrual is recording of revenue or expense in


advance of when it is paid; it is the opposite of a deferral.

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Accrued revenue is revenue that is recorded because it is


earned, though the
company has not yet received the
cash.
Example: On June 15, Fed Express hires the company to wash their trucks, agreeing
to pay $600 a month; the first payment will be made July 15th. The company
performed half a months service at the end of June.
Since we have performed a service, revenue is earned and must be recorded.
Date
June 30

Accounts
Debit
Credit
Accounts Receivable
300
Service Revenue
300
To record revenue earned in the month
of June.
Accounts
Receivable
Reference
Debit (+)
Credit (-)
Reference
July 15th (when paid)
600
June 30 Cash
300
Accounts Receivable
300
Total
300
0 Total
Service Revenue
300
debits
Credits
Balance (July)
300
6/30
th
To record receipt of payment for one months service (1/2
June15
and
in July)
300in July
Total
Total
debits
300
300 Credits
Balance
7/31
0

Reference
Total
debits

Service Revenue
Debit (-)
Credit (+)
Reference
300 June 30
Total
0
300 Credits
Balance
300 6/30
300 July 15
Balance
600 7/31

Accrued expense are expenses recorded because they have been incurred,
though the company has not yet paid for them; examples
are wages, interest,
income taxes.
Example: The company pays salaries of 1,800 per month, half on the 15 th
and half on the 30th. If
the last day of the month falls on a weekend, they pay the
following Monday. Assume that June 30th fell on Sunday. The company must
record the wage expense at the end of June even
though they do not pay it
until July.
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Date
June 15

Accounts
Debit
Credit
Salary Expense
900
Cash
To record wage expense for the first Salary
half of the
month.
Expense
Reference
Debit (+)
Credit (-)
Reference
June 30
900
June 15 Salary Expense
900
Salary
Payable
June 30
900
To record wage expense
half of the month.0 Total
Total for the second
1,800
debits
Credits
July 1 (when paid)
900
Balance Salary Payable
1,800
Cash
To pay Junes payroll.

Reference
Total
debits
July 1

900

900

900

Salary Payable
Debit (-)
Credit (+)
Reference
900 June 30
Total
0
900 Credits
900 Balance
900
0 Balance

Example: The company determines it will owe income taxes of 600 on the
income earned during June.
Date
June 30

Accounts
Debit
Credit
Income Tax Expense
Income
tax(+)
expense
600
Reference
Debit
Credit (-)
Reference
Income
tax
payable
June 30
600
To record income tax
expense.
Total
600
0 Total
debits
Credits
When paid
Income
Tax
Payable
600
Balance
600
Cash
To record payment of previously accrued taxes.

Reference
Total
debits
When
Paid

Income Tax Payable


Debit (-)
Credit (+)
Reference
600 June 30
Total
0
600 Credits
600 Balance
600
0 Balance

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600

600

D.

Summary of the Process


Purpose:

Measure income for the period (income statement); make sure all
revenue and expense is recorded in the proper period
Update the balance sheet make sure assets and liabilities are not
over or under stated.
Adjusting Entries:

Will have at least one revenue or one expense


Will have at least one asset or liability
Type of Account

Category of Adjusting Entry


Prepaid expense
Unearned revenue
Depreciation
Accrued revenue
Accrued expense
E.

Debit
Expense
Liability
Expense
Asset
Expense

Credit
Prepaid Asset
Revenue
Contra asset
Revenue
Liaiblity

Adjusted Trial Balance

The original (unadjusted trial balance) now needs to be updated for the
adjusting entries. Post
the entries in debt and credit adjustment columns and
recomputed the ending balances. Think
of the trail balance account row as a T
account.

ShineBrite Car Wash, Inc.


Adjusted Trial Balance
As of June 30, 2010
Trial Balance
Accounts
Cash
A/R
Supplies
Prepaid Rent
Equipment
A/D Equipment
A/P
Salary payable
Unearned Service
Revenue

Debit
24,800
2,200
700
3,000
24,000

Credit

Debit

Credit

300
300
1,000
400
13,100
900
400

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Adjustments

200

Adjusted Trial
Balance
Debit
Credit
24,800
2,500
400
2,000
24,000
400
13,100
900
200

Income tax payable


Common Stock
Retained Earnings
Dividends
Service Revenue
Rent expense
Salary expense
Supplies expense
Depreciation expense
Utilities expense
Income tax expense
Total

600

600
20,000
18,800

20,000
18,800
3,200

3,200
7,000

300
200
1,000
900
300
400

900
500
59,300

59,300

600
3,700

3,700

7,500
1,000
1,800
300
400
500
600
61,500

61,500

Once the adjusted trial balance is balanced, prepare income statements.


F.

Closing Entries

Closing the books means to prepare the accounts for the next accounting
period. Closing
entries close temporary accounts (revenue, expense, and
dividends) to retained earnings.
Closing the accounts sets their balance to
zero so that they are ready to measure transactions
for the next period.
Process:
1. Debit (decrease) each revenue account for its balance and credit RE
(increase)
2. Credit (decrease) each expense account for its balance and debit RE
(decrease).
3. Credit (decrease) dividends for its balance and debit RE (decrease).
Date
June 30

Accounts
Service revenue
Retained earnings

Debit

Credit
7,500
7,500

To close revenue into RE.


June 30

Retained Earnings
Rent expense
Salary expense
Supplies expense
Depreciation expense
Utilities expense
Income tax expense

4,600

Retained Earnings
Dividends

3,200

1,000
1,800
300
400
500
600

To close expenses to RE.


June 30
To close dividends to RE.
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3,200

Each revenue and expense account now has a zero balance. The RE equity account
now reflects the current period income and dividend activity.
Reference

Retained Earnings
Debit (-)
Credit (+)

Exp 6/30
Div 6/30
Total
Debits

Reference
Beg Bal
18,800 6/1
7,500 Rev 6/30

4,600
3,200
7,800

Total
26,300 Credits
End Bal
18,500 6/30

The RE account is an example of a permanent account. A permanent account


remains open and carries over to the next period. Thus, every permanent account
will have a beginning balance, current period activity, and an ending balance. The
ending balance of one period becomes the beginning balance of the next period.
The permanent accounts are assets, liabilities, and equity.
G.

The Accounting Cycle

II.

Business transactions occur


Record transactions in chronological order via journal entries
Post journal entries to accounts
Compute account balances and prepare a preliminary or unadjusted
trial balance
Examine accounts and prepare adjusting entries (journalize)
Post adjusting entries to accounts and to the adjusted trial balance
Prepare the financial statements
Close the temporary accounts to RE

Classified Accounts and Financial Statements


A.

Account Classification

Accounts can be classified according to their liquidity.


Liquidity measures how quickly an item can be converted to cash. Cash is
the most liquid asset.
A/R is fairly liquid as customers will pay in a short amount
of time. Inventory is less liquid you have to first sell the inventory and then
collect the cash. Plant assets are less liquid because
they are held for use for
long periods of time (not for sale). Assets and liabilities are listed on a balance
sheet in order of liquidity.
We can also classify according to time as current or long-term.
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A current asset or liability is one that will be used, converted to cash, or


consumed within the
next twelve months or within the businesss normal
operating cycle if longer than one year. The operating cycle, also called cash-tocash, is the time period from payment for goods or services
to collection from
customers for the sale of the goods or services.
All other assets and liabilities not classified as current are considered longterm. An asset or liability can fit both categories. For example, assume you have
a long-term loan with a bank. A
portion of the loan will be due within the next
twelve months (current portion) but there is also
a portion that will be due
beyond the next twelve months (long-term portion).
B.

Classified Balance Sheets

A classified balance sheet is one in which the assets and liabilities are
reported in current and long-term sections and in the order of liquidity within each
section.
C.

Financial Statement Formats


Balance sheet two common formats
Report format assets at top; liabilities and equity on bottom
Account format assets on left; liabilities and equity on right.
Income Statement single-step and multi-step

Single step one computation (revenue expenses) determines


income; all revenues
and gains listed in a general revenue
category; all expenses and losses listed in a general
expense category.
Multi-step: contains multiple computations (and subtotals) to arrive at
income; each
subtotal has meaning. Common subtotals include
gross profit, income from operations
(EBIT), and income before
taxes, before arriving at net income.
Accounts:
Net Revenue
Cost of Goods Sold
Gross Margin
(Profit)
Operating
Expenses
Operating Income
Other
income/expense
Income Before Tax

- XXXXXXX

Explanation
What you earned from selling the product
Cost of the product you sold
Whats left from revenue after the cost of the
product, to cover operating expenses
Cost to operate your business

XXXXXXXX
+ or XXX

Income from normal operations


Non-operations revenue and expense

XXXXXXXX

Income on which you must pay tax

XXXXXXXX
- XXXXXXX
XXXXXXXX

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Taxes
Net Income
D.

- XXXXXXX
XXXXXXXX

The net, after taxes and all other expenses

Account Relationships, Classifications, and Ratios

We classify accounts and statements to provide more meaningful information


to users. We can use these to calculate ratios ratios help users to evaluate a
company.
1.
its current
available

Current Ratio: measures liquidity the ability of the company to pay


obligations based on the amount of current assets

Current assets / Current liabilities = number of times current assets cover


current liabilites
1,748 / 2,190 = .80 times
Ratio of 1: company has exactly the same amount of current assets as it
does current liabilities;
they can cover their obligations once with current assets.
Ratio > 1: company has more current assets than liabilities; can cover the
liabilities more than
once.
Ratio < 1: the company does not have enough current assets to cover its
current liabilities; can
only cover a portion of them. Example above; company
can pay 80% of its current liabilities
with the current assets it has

Most successful companies operate between 1.20 and 1.50.


1.00 is considered low.
Compare to others within the same industry.
Look at trend: Increasing ratio from prior period indicates
improvement in financial position.

2.
Debt Ratio: measures solvency the companys ability to pay all its
obligations, both
current and long-term.
Total liabilities/ Total Assets = % of companys assets that is financed with
debt
3,182 / 5,673 = 56%

The higher the ratio, the greater the risk that the company cannot
meet its obligations
The norm for this ratio is 60% to 70%.
Compare to others within the same industry.

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3.

Transactions Impact Ratios

Transaction impact ratios when the transaction impacts an account


used in the
calculation of the ratio. Companies pay a great
deal of attention to how things impact
their ratios.

Consider the following scenarios:


1.
2.
3.
4.
5.
6.
7.

Sold stock for cash 50.


Purchased building for 20.
Sold 30 on account.
Collected 30 on account.
Accrued 40 in expenses.
Recorded 80 of depreciation.
Earned and collected 40 of interest revenue.

Current Assets

Current
Liabilities

#1

1,748
+50
1,798

#2
#3
#4

Total
Liabilities

Total Assets

Debt
Ratio

2,190

Curre
nt
Ratio
.7982

3,182

56%

2,190

.8210

3,182

5,673
+50
5,723

-20
1,778

2,190

.8119

3,182

-20 + 20
5,723

+30
1,808

2,190

.8256

3,182

+30
5,753

+30 30
1,808

2,190

.8256

3,182

+30 30
5,753

1,808

+40
2,230

.8108

+40
3,222

5,753

#5
#6
#7

1,808

2,230

.8108

3,222

-80
5,673

+40
1,848

2,230

.8287

3,222

+40
5,713

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55.60
%
55.60
%
55.31
%
55.31
%
56.01
%
56.80
%
56.40
%