Ch 3 Notes

The Accrual Basis of Accounting Chapter 3 A200 - Survey of Accounting University of Tennessee Spring 2009 Objectives Describe basic accrual accounting concepts, including the Matching Concept. Use accrual concepts of accounting to analyze, record, and summarize transactions. Describe and illustrate the end-of-period adjustment process. Prepare financial statements using accrual concepts of accounting, including a classified balance sheet. Omit Obj. 5 Obj. 1: Basic accrual accounting concepts, including the Matching concept. Accrual Accounting: Record business transactions when they occur. Revenue is recorded when it is earned, whether or not cash is received. Expenses are recorded when they are incurred, whether or not cash is paid. All business transactions affect the accounting equation (Assets = Liabilities + Equity) either directly, or indirectly through net income. Matching Concept: Revenue is recorded in the same period as the Expenses that helped generate the revenue. Obj. 2: Analyze, record, and summarize transactions Recording Revenue Businesses record Revenue when it is earned: Increase Revenue, which increases Net Income, which increases Retained Earnings (equity). a. If cash is received at the same time: Increase Cash (asset). b. If cash will be received in the future: Increase Accounts Receivable (asset). This is accrued revenue. c. If cash was previously received: Decrease Unearned Revenue (liabilities). This is deferred revenue. Obj. 2: Analyze, record, and summarize transactions Recording Revenue Flatt Corporation, a consulting firm, began business on April 1, 2009. During April, Flatt engaged in the following transactions: Flatt rendered services to clients for $12,000 cash. Cash was received when revenue was earned, so Flatt records: Assets = Liabilities + Equity Cash Retained Earnings 12,000 = 12,000 Revenue was earned and Cash was received in the same period, so no end-of-period adjustment will be necessary. Obj. 2: Analyze, record, and summarize transactions Recording Revenue Flatt rendered services to clients and billed them for $3,000. Revenue has been earned. Cash will be received later, so Flatt records: Assets = Liabilities + Equity Accounts Receivable Retained Earnings 3,000 = 3,000 When cash is received, Flatt will increase Cash and decrease Accounts Receivable. Accrued Revenue: Revenue is recorded before Cash is received. We record Revenue when it is earned. Obj. 2: Analyze, record, and summarize transactions Recording Revenue Flatt received $4,500 in advance from Scruggs Company for six months rent on a vacant office in Flatt?s building. Cash has been received. Revenue will be earned month by month as Scruggs uses the office space, so Flatt records: Assets = Liabilities + Equity Cash Unearned Rent 4,500 = 4,500 An end-of-period adjustment will be necessary to record Revenue earned (see Slide #14). Deferred Revenue: Cash is received before Revenue is recorded. We record Revenue only when it is earned. Obj. 2: Analyze, record, and summarize transactions Recording Expenses Businesses record Expenses when they are incurred: Increase Expense, which decreases Net Income, which decreases Retained Earnings (equity). a. If cash is paid at the same time: Decrease Cash (asset). b. If cash will be paid in the future: Increase Accounts Payable (liability). This is Accrued Expense. c. If cash was previously paid: Decrease Prepaid Expense (asset). This is Deferred Expense. Obj. 2: Analyze, record, and summarize transactions Recording Expenses Flatt Corporation paid a utility bill (heat and air for the month) totaling $1,700. Cash was paid and Expense was incurred (Flatt used the utilities) at the same time, so Flatt records: Assets = Liabilities + Equity Cash Retained Earnings (1,700) = (1,700) Expense was incurred and Cash was paid in the same period, so no end-of-period adjustment will be necessary. Obj. 2: Analyze, record, and summarize transactions Recording Expenses Flatt Corporation hired a cleaning company to clean its offices, but has not yet paid the bill. Flatt owes $600. The Expense was incurred (Flatt used the services), but Cash has not yet been paid, so Flatt records: Assets = Liabilities + Equity Accounts Payable Retained Earnings 600 (600) When cash is paid, Flatt will decrease Cash and decrease Accounts Payable. Accrued Expense: Expense is recorded before Cash is paid. We record Expense when it is incurred (used). Obj. 2: Analyze, record, and summarize transactions Recording Expenses Flatt paid a $2,400 premium on a one-year general business insurance policy. Cash was paid. Expense will be incurred month by month, as Flatt uses the insurance coverage, so Flatt records: Assets = Liabilities + Equity Cash Prepaid Insurance (2,400) 2,400 An end-of period adjustment will be necessary to record the Expense incurred (see Slide #16). Deferred Expense: Cash is paid before Expense is recorded. We record Expense when it is incurred (when we use the asset to help generate revenue). Obj. 2: Analyze, record, and summarize transactions not involving Revenue or Expense Flatt purchased $20,000 of land, giving a note payable due in 2012: Assets = Liabilities + Equity Land Note Payable 20,000 = 20,000 Flatt issued capital stock for $50,000 cash: Assets = Liabilities + Equity Cash Capital Stock 50,000 = 50,000 Neither of these transactions requires an EOP adjustment. Obj. 3: End-of-period (EOP) Adjustments answer four Matching questions EOP Adjustments are necessary because not all accounts are up to date at the point Flatt must prepare financial statements (end of accounting period). Have we earned any revenue for which we have not yet received cash? Accrued Revenue On April 30, the end of the first month, Flatt found that $5,500 of services had been rendered to clients but not yet billed. Revenue has been earned. Cash will be received later, so Flatt records: Assets = Liabilities + Equity Accounts Receivable Retained Earnings 5,500 = 5,500 Obj. 3: End-of-period (EOP) Adjustments answer four Matching questions Have we now earned any revenue for which we received cash earlier? Deferred Revenue When Cash was received: Flatt increased Cash (asset) and increased Unearned Rent (liability) (see Slide #7) Revenue is now earned: On April 30, the end of its first month, Flatt adjusts the accounts to reflect one month of rent revenue earned on the Scruggs rental ($4,500 ÷ 6 months = $750 per month). Flatt records: Assets = Liabilities + Equity Unearned Rent Retained Earnings (750) 750 Obj. 3: End-of-period (EOP) Adjustments answer four Matching questions: Have we incurred any expense for which we have not yet paid cash? Accrued Expense Since it last paid wages, Flatt Corporation has used more of its employees? labor. On April 30, Flatt owes employees $1,000, which it will pay in May. Flatt adjusts the accounts to record the wage expense: Assets = Liabilities + Equity Wages Payable Retained Earnings 1,000 (1,000) When cash is paid, Flatt will decrease Cash (asset) and decrease Wages Payable (liability). Obj. 3: End-of-period (EOP) Adjustments answer four Matching questions Have we incurred any expense for which we paid cash earlier? Deferred Expense On April 30, Flatt adjusts the accounts to reflect one month of insurance expense (prepaid insurance coverage used.) $2,400 ÷ 12 months = $200 per month. Flatt records: Assets = Liabilities + Equity Prepaid Insurance Retained Earnings (200) = (200) Obj. 2 & 3: Summary of transactions and adjustments Copy each of the transactions (Slides 5-16) and total the accounts. Assets = Liabilities + Equity Cash Accounts Prepaid Land Accounts Unearned Wages Note Capital Retained Receivable Insurance Payable Rent Payable Payable Stock Earnings 5. 12,000 12,000 6. 3,000 3,000 7. 4,500 4,500 9. (1,700) (1,700) 10. 600 ( 600) 11. (2,400) 2,400 12. 20,000 20,000 12. 50,000 50,000 13. 5,500 5,500 14. (750) 750 15. 1,000 (1,000) 16. (200) ( 200) 62,400 8,500 2,200 20,000 = 600 3,750 1,000 20,000 + 50,000 17,750 Obj. 2 & 3: Summary of transactions and adjustments On April 30, Flatt Corporation prepares financial statements: Flatt Corporation Income Statement For the month ended April 30, 2009 Revenues: Fees Earned ($12,000 + 3,000 + 5,500) $20,500 Rent Revenue 750 $21,250 Expenses: Utilities expense 1,700 Wages expense 1,000 Office expense 600 Insurance expense 200 ( 3,500) Net Income: $17,750 Net Income increases Retained Earnings. Obj. 2 & 3: Summary of transactions and adjustments Flatt Corporation Statement of Retained Earnings for the month ended April 30, 2009 Beginning Retained Earnings, 4-01 $ 0 Net Income for April 17,750 Dividends ( 0) Ending Retained Earnings, 4-30 $17,750 Retained Earnings is part of Equity on the Balance Sheet. The Balance Sheet is now a Classified Balance Sheet. Obj. 4: Classified Balance Sheet Current Assets: The portion of assets that will be used to help generate revenue within one year. Long-term Assets: The portion of assets that will be used to help generate revenue over longer than one year. Current Liabilities: The portion of business debt (creditors? claims on assets) that will be paid off (satisfied) within one year. Long-term Liabilities: The portion of business debt (creditors? claims on assets) that will be paid off (satisfied) in more than one year. Stockholders? Equity: Owners? claims on assets. Obj. 4: Classified Balance Sheet Flatt Corporation Balance Sheet (see Slide #17) as of April 30, 2009 Assets Liabilities Current Assets: Current Liabilities: Cash $ 62,400 Accounts Payable $ 600 Accounts Receivable 8,500 Unearned Rent 3,750 Prepaid Insurance 2,200 Wages Payable 1,000 Total Current Assets: $ 73,100 Total Current Liabilities: $ 5,350 Fixed (Long-term) Assets: Long-term Liabilities: Land 20,000 Note Payable 20,000 Total Long-term Assets: 20,000 Total Long-term Liabilities: 20,000 Stockholders? Equity Common Stock 50,000 Retained Earnings 17,750 Total Stockholders? Equity: 67,750 Total Liabilities and Total Assets: $ 93,100 = Stockholders? Equity: $ 93,100 Accrual-basis accounting enhances the interpretation of financial statements. Comparability: Accrual-basis accounting is required by GAAP (generally accepted accounting principles) for all publicly-traded companies. - makes all companies? financial statements comparable (same information in the same format). - helps business stakeholders make informed decisions about the health and future prospects of companies. Matching: Accrual-basis accounting properly matches Revenues with the Expenses it took to generate those revenues. Profitability: Accrual-basis accounting reports Net Income, which is one indicator of the short-term profitability of a business. Financial Statement Analysis Ratios Chapter 3 Current Ratio = Current Assets ÷ Current Liabilities This ratio measures the short-term solvency (debt-paying ability) of the company and the company?s ability to borrow short-term. Analyzing Flatt Corporation?s balance sheet (slide 21): Current Ratio = Is this number good or bad? Can?t tell without Horizontal Analysis. If Flatt?s current ratio in 2008 was 12.5, what can we say about the trend? If Flatt?s current ratio in 2008 was 14.2, what can we say about the trend?