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The Accrual Basis of Accounting Chapter 3 A200 The difference between Cash Basis accounting and Accrual Basis accounting is the point in time that Revenues or Expenses are recorded. Cash Basis Accrual Basis Revenue is recorded When Cash When revenue is received is earned* even if cash is not received. Expenses are recorded When Cash When expenses is paid are incurred* in generating revenues even if cash is not paid. *Earned = You?ve done the work and have a right to be paid. Incurred = Come up and must be paid either immediately or in the future. This properly matches revenues with expenses in the same accounting period which is what the Matching Principle of accounting says must be done. Under the accrual basis of accounting, Revenues are recorded as income is earned, not necessarily when cash is received. 10/1 Pawpaw Health Care Inc. received $4,500 from Embark Co. for 6 months of rent to use the vacant office in Pawpaw Health Care?s building. The entry is + Cash $4,500 and + Unearned Rent $4,500. Assets = Liabilities + Equity Cash Unearned Rent C/S R/E + $4,500 = + $4,500 Revenues ? Expenses = Net Income 0 = 0 notice: we received cash, but did not record revenue. This is called a Deferred Revenue because we have to Delay recording Revenue until Revenue is actually earned (even though they?ve already paid us the cash.) At the end of the first month, 10/31, we adjust the accounts to reflect 1 month of rent actually earned. ($4,500/6months = $750 per month earned) The entry is + Rental Rev $750 and ? Unearned Rent $750. Assets = Liabilities + Equity Cash Unearned Rent C/S R/E + $4,500 = + $4,500 . = - 750 +750 rental revenue bal. $3,750 Revenues ? Expenses = Net Income We have now earned 1/6 of the cash Rental Revenue previously received. 750 - 0 = 750 This is called the adjustment process. Adjustments update the accounts. Under accrual accounting, expenses are recorded in the same period as the revenues they helped generate (matching principle), not necessarily when cash is paid. 10/1 Pawpaw paid $2,400 in cash for an insurance premium on a one year general business policy. The entry is: - Cash $2,400 and + Prepaid Insurance $2,400. Assets = Liabilities + Equity Cash Prepaid Insurance Unearned Rent C/S R/E - $2,400 + $2,400 Revenues ? Expenses = Net Income We are essentially trading one asset 0 = 0 for another at this point. This is called a Deferred Expense because we have to Delay recording an expense even though cash is spent until we actually use the new asset Prepaid Insurance to generate income. At the end of the first month, 10/31, we adjust the accounts to reflect 1 month of prepaid insurance actually used up. 2,400/12months = $200 per month The entry is: - Prepaid Insurance $200 and + Insurance expense 200 Assets = Liabilities + Equity Cash Prepaid Insurance = Unearned Rent C/S R/E - $2,400 + $2,400 - $200 ($200) insurance exp bal. $2,200 Revenues ? Expenses = Net Income An Asset used up = An Expense Insurance exp. 200 = (200) This is called the adjustment process. Adjustments update the accounts. All accounts must be updated before Financial Statements can be prepared at the end of any accounting period. It is now 12/31 and Pawpaw?s Healthcare has provided $1,500 in services for 3 patients who have not been sent a bill. Pawpaw wants to prepare Financial Statements for the year. Revenues must be Accrued (added) so that they are included in the current period Income Statement because these revenues have been Earned. The entry is + A/R $1,500 and + Fees Earned $1,500. Assets = Liabilities + Equity Cash A/R C/S R/E + $1,500 +$1,500 fees earned Revenues - Expenses = Net Income Fees earned $1,500 = $1,500 This is called an Accrued Revenue. It is an adjustment at the end of any accounting period. It?s 12/31 and Pawpaw?s employees have worked 12/29 and 12/30. They will not be paid cash until the next period (January). Pawpaw wants to prepare financial statements for the year. Amounts owed to employees for the current year are $1,000. In this case, a wages expense must be Accrued (added) so that they are included in the current period Income Statement and matched with revenues those workers helped generate. The entry is: + Wages Expense $1,000 and + Wages Payable $1,000 Assets = Liabilities + Equity Cash Wages Payable C/S R/E + $1,000 ($1,000) wages expense Revenues - Wages Expense = Net Income 1000 = (1000) This is an Accrued Expense and is the end of the period adjustment. The four types of adjustments are: Deferred Revenues: are revenues we delay recording because they have not been earned (even though cash is received) Ex. Unearned Rent Deferred Expenses: are expenses we delay recording because they have not really been incurred (even though cash is spent) Ex. Prepaid Insurance Accrued Revenues: are revenues we need to add to the accounting equation because we have earned them (even though cash has not been received). (Ex. A/R and Sales Revenue) Accrued Expenses: are expenses we need to add to the accounting equation because we have incurred them (even though cash had not been paid.) (Ex. Wages Expense and Wages Payable) 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 for 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. Balance Sheet Assets Liabilities Current Assets: Current Liabilities: Cash $734,000 Accounts Payable $ 95,700 A/R 361,000 Notes Payable 360,000 Inventories 512,000 L/T Assets: L/T Liabilities: Land 1,534,900 Notes & other debt 1,045,000 Building 429,000 Patent 212,800 Stockholders? Equity Capital Stock $183,000 Retained Earnings 2,100,000 Total Liabilities & Total Asset: $3,783,700 Stockholders Equity: $3,783,700