Financial Accounting

Chapter 3
Learning Objectives

3.1 Explain how accrual accounting differs from cash-basis

accounting
3.2 Apply the revenue and expense recognition principles
3.3 Adjust the accounts
3.4 Prepare updated financial statements
3.5 Close the books
Accrual Accounting and
Cash-Basis Accounting

Accrual Accounting
• Records impact of transactions when they occur
• Records:
– Income when earned
– Expenses when incurred
Accrual Accounting and
Cash-Basis Accounting

Cash-Basis Accounting
• Records only cash transactions
– Cash receipts
– Cash payments
• Fails to capture the underlying economic phenomenon
• Results in incomplete financial statements
• Only used by businesses that do not follow accounting
standards
Accrual Accounting and
Cash-Basis Accounting

• Accrual accounting records cash transactions, such as:

– Collecting cash from customers
– Receiving cash from interest earned
– Paying salaries, rent, and other expenses
– Borrowing money
– Paying off loans
– Issuing shares
Accrual Accounting and
Cash-Basis Accounting

• The Time-Period Concept

– Accounting information is reported at regular intervals
– Basic accounting period is one year
– Companies also prepare financial statements for interim
periods
Revenue and Expense
Recognition Principles

The Revenue Principle

• Deals with two issues:
– When to record (recognize) revenue
– What amount of revenue to record
Revenue is recognized when:
– risks and rewards of ownership of the goods has transferred to the
buyer
– the entity retains neither continuing managerial involvement
usually associated with ownership nor effective control over goods
sold
Revenue and Expense
Recognition Principles

The Revenue Principle

Revenue is recognized when:
– the amount of revenue can be measured reliably
– it is probable that the economic benefits associated with the
transaction will flow to the entity
– the costs incurred or to be incurred in respect of the transaction can
be measured reliably
Revenue and Expense
Recognition Principles

The Expense Recognition Principle

• Includes two steps:
– Identify all expenses incurred during the period
– Measure the expenses and recognize them in the same
period in which any related revenues are earned
• To recognize an expense along with related revenues means
to subtract expenses from related revenues to compute net
income or net loss.
Revenue and Expense
Recognition Principles

The Matching Concept explains the relationship between

expenses and revenues
Includes two steps:
– Identify all expenses incurred during the period
– Measure the expenses and recognize them in the same
period in which any related income is earned
• The change in assets and liabilities determines profit or loss,
not the application of a matching concept.
The Matching Concept
Unadjusted Trial Balance
Categories of Adjusting Entries

• Deferrals
– An adjustment for payment of an item or receipt of cash in
advance.
• Accruals
– The opposite of a deferral.
• Depreciation
– Allocates the cost of Property, Plant and Equipment (PPE)
to expense over the asset’s useful life.
Adjust the Accounts (1 of 6)

Prepaid Expenses
An expense paid in advance. Prepaid expenses are assets
because they provide a future benefit for the owner.
Prepaid Expenses (1 of 4)

Prepaid Rent: Suppose RedLotus’ Travel Inc., prepays three

months’ store rent ($3,000) on June 1.
Prepaid Expenses (2 of 4)

Prepaid Rent. Throughout June, Prepaid Rent carries the balance of

$3,000. At June 30, an adjusting entry is required to transfer $1,000
($3,000 ÷ 3) from Prepaid Rent to Rent Expense.
Prepaid Expenses (3 of 4)

Supplies. On June 2, RedLotus paid cash of $700 for cleaning supplies.

Prepaid Expenses (4 of 4)

Supplies. A count at June 30 indicates that $400 of supplies

remain on hand.
Adjust the Accounts (2 of 6)

Unearned Service Revenue

• Receipt of cash before earning the revenue creates a liability
Unearned Service Revenue (1 of 2)

Suppose another hotel chain engages RedLotus Travel, paying them

commissions in advance to make 10 bookings within 30 days.
Assume RedLotus collects $400 on June 15.
Unearned Service Revenue (2 of 2)

During the last 15 days of the month, RedLotus books five clients into
the hotel to earn ½ of the $400.
Adjust the Accounts (3 of 6)

Accrued Expenses
• A liability that arises from an expense that has not yet been
paid
• Not recorded daily or weekly, but rather at the end of the
period as an adjusting entry
Accrued Expenses (1 of 4)

Accrued Salary Expense. Suppose RedLotus Travel, Inc. pays

its employee a monthly salary of $1,800, half on the 15th and
half on the last day of the month. The following calendar for
June has the paydays circled:

Assume that if a payday falls on a Sunday, RedLotus’ pays the employee

on the following Monday.
Accrued Expenses (1 of 3)

During June, RedLotus Travel paid its employee the first half-month
salary of $900.
Accrued Expenses (2 of 3)

The second half-month amount of $900 will be paid on Monday, July 1.

At June 30, therefore, RedLotus Travel makes the adjusting entry.
Adjust the Accounts (4 of 6)

Accrued Revenues
• A revenue that has been earned but not yet collected.
Accrued Revenues (3 of 3)

Assume that on June 15 a hotel agrees to pay RedLotus a commission

of $30 per booking into its hotel over the next 30 days. RedLotus books
10 clients in June and earns $300, for work done in June.
Prepaid and Accrual Adjustments
Adjust the Accounts (5 of 6)

Depreciation of Property, Plant and Equipment

• Plant assets are long-lived tangible assets, such as land,
buildings, furniture, and equipment.
• Depreciation is the process of allocating cost to expense for a
long-term plant asset.
– Decline in usefulness
– Spread the cost of the plant asset over its useful life
– Exception: Land – does not decline in usefulness
Depreciation of Plant Assets (1 of 4)

Equipment. Suppose that on June 2 RedLotus purchased

equipment on account for $24,000
Depreciation of Plant Assets (2 of 4)

Straight-line depreciation method:

• Divide cost of the asset by its useful life
• RedLotus Travel Inc. Equipment:
Cost: $24,000
Useful life: 5 years

24,000
Annual depreciation  year = 4,800 per year
5
4,800
Monthly depreciation  months = 400 per year
12
Depreciation of Plant Assets (3 of 4)

Depreciation expense for June is recorded as follows:

Depreciation of Plant Assets (4 of 4)

Accumulated Depreciation
• Shows the sum of all depreciation expense
• The balance increases over the asset’s life
• Contra asset account, a normal credit balance.
• A contra account has two distinguishing characteristics:
– Always has a companion account
– Normal balance is opposite that of the companion account
Plant Assets

Book Value: Cost of the plant asset minus accumulated

depreciation
Income Tax Accrual

RedLotus Travel, Inc. would make an additional adjusting entry to

accrue income tax expense of $600 and the related income tax
payable as the final adjusting entry of the period.
Summary of the Adjusting Process

• Two purposes of the adjusting process are to

– measure income, and
– update the balance sheet.
• Therefore, every adjusting entry affects both of the following:
– Revenue or expense—to measure income
– Asset or liability—to update the balance sheet
Summary of Adjusting Entries
The Adjusting Process of
RedLotus Travel, Inc.
The Adjusting Process of
RedLotus Travel, Inc.
Adjust the Accounts (6 of 6)

The Adjusted Trial Balance

Summarizes all accounts and their final balances after all
adjusting entries have been journalized and posted
Adjusted Trial Balance
Construct the Financial Statements

The June financial statements of RedLotus Travel, Inc. can be

prepared from the adjusted trial balance.
Income Statement
Statement of Changes in Equity
Balance Sheet
Close the Books (1 of 3)

• Prepares the accounts for the next period

• Close temporary accounts: accounts related to a limited
period of time
– Income
– Expenses
– Dividends
• Do NOT close permanent accounts
– Assets
– Liabilities
– Shareholders’ equity
Close the Books (2 of 3)

Steps to close the books:

1. Debit each income for the amount of its credit balance.
Credit Retained Earnings for the sum of all revenues.
2. Credit each expense account for the amount of its debit
balance. Debit Retained Earnings for the sum of all expenses.
3. Credit the Dividends account for the amount of its debit
balance. Debit Retained Earnings for the same amount.
Journalizing and Posting
the Closing Entries
Journalizing and Posting
the Closing Entries
Close the Books (3 of 3)