HARAR POLYTECHNIC COLLEGE

Accrual Accounting and the

Financial Statements
Accounting level 4

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 Learning Objective 1
Relate accrual accounting and cash flows.

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 Accrual Accounting vs Cash Basis
Accounting
• Accrual Accounting - records the impact of a business
event as it occurs
• Cash Basis – records only transactions in which cash is
received or paid
• The cash basis considers only cash receipts and cash
payments for the year
• As a result, both the Revenue Recognition and the
Matching Principle are ignored
• Cash basis financial statements do not conform to
GAAP
• Accrual basis considers revenues when earned and
expenses when consumed in determining net income

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 The Time-Period Concept
Financial statements are prepared for specific
periods and at regular intervals.

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 Learning Objective 2
Apply the revenue and matching principles.
Revenue Principle
• Revenue is recorded when it is earned.
• The amount of revenue to record is the cash
value of goods transferred to customer.
The Matching Principle
• Record all expenses incurred during the
accounting period
• Match expenses against revenues earned
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 Learning Objective 3
Update the financial statements by adjusting the accounts.
Air & Sea Unadjusted Trial Balance April 30, 20x3
Account Debit Credit
Cash $24,800
Accounts receivable 2,250
Supplies 700
Prepaid rent 3,000
Furniture 16,500
Accounts payable 13,100
Unearned service revenue 450
Common stock 20,000
Retained earnings 11,250
Dividends 3200
Service revenue $7,000
Salary expense 950
Utilities expense 400
Total wondiye T.
$51,800 $51,800 6
Categories of Accounting Adjustments
• Deferrals
• Depreciation
• Accruals

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 Prepaid Expenses: Rent
On April 1, 20x3, Air & Sea Travel prepays three
months office rent.

Prepaid Rent Cash

3,000 3,000

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 Prepaid Expenses: Rent
What is the adjusting entry on April 30?

General Journal
1,000
Date Accounts and Explanations PR Debit Credit

April 30 Rent Expense 1,000

Prepaid Rent 1,000

To record rent expense

($3,000 x 1/3)

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 Prepaid Expenses: Supplies
On April 2, 20x3, Air & Sea Travel paid cash of
$700 for office supplies.

Supplies Cash
700 700

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 Prepaid Expenses: Supplies
An inventory at month end indicated that $400
in office supplies remained.

Supplies Supplies Expense

4/2 700 4/30 300 4/30 300
Bal. 400 Bal. 300

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 Depreciation
• Allocation of the cost of a plant asset to
expense over the asset’s useful life

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 Depreciation of Plant Assets
On April 3, the business purchased furniture on
account for $16,500. The furniture is expected
to last 5 years.

Furniture Accounts Payable

16,500 16,500

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 Depreciation of Plant Assets
• Straight-line method of depreciation allocates
equal amounts each accounting period.
• $16,000 ÷ 5 years = $3,300 per year
• $3,300 ÷12 months = $275 per month

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 Depreciation of Plant Assets
What is the adjusting entry on April 30?

General Journal
Date Accounts and Explanations PR Debit Credit
April 30 Depreciation Expense, Furniture 275
Accumulated Depreciation,
Furniture 275
To record depreciation

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 Book Value
The net amount of a plant asset (cost minus
accumulated depreciation)

Plant Assets of Air & Sea at April 30, 20x5

Furniture $ 16,500
Less Accumulated Depreciation (275) $ 16,225
Building $ 48,000
Less Accumulated Depreciation (200) 47,800
Book value of plant assets $ 64,025

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 Accrued Expense
• A liability that arises from an expense that has
not yet been paid.
• Air & Sea Travel pays its employees a monthly
salary of $1,900, half on the 15th and half on
the last day of the month. If a payday falls on
the weekend, Air & Sea pays the employee on
the following Monday.

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 Accrued Expenses

Salary Expense Cash

4/15 950 4/15 950
4/30 950
Bal. 1,900
Salary Payable
4/30 950
Bal. 950

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 Accrued Revenue
• A revenue that has been earned but not
received in cash.
• Bank One hires Air & Sea Travel on April 15 to
arrange travel services on a monthly basis.
Bank One will pay the travel agency $500
monthly, with the first payment on May 15.

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 Accrued Revenues
Adjusting entry:

General Journal
Date Accounts and Explanations PR Debit Credit
April 30 Accounts Receivable 250
Service Revenue 250
To accrue service revenue

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 Unearned Revenue
• An obligation arising from receiving cash
before providing a service.
• Plantation Foods engages Air & Sea Travel
agreeing to pay the agency $450 monthly,
beginning immediately. Air & Sea Travel
collects the first amount on April 20 and earns
one-third the last 10 days.

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 Unearned Revenues
General Journal
Date Accounts and Explanations PR Debit Credit
April 20 Cash 450
Unearned Revenue 450
Received advanced payment

General Journal
Date Accounts and Explanations PR Debit Credit
April 30 Unearned Revenue 150
Revenue 150
To record revenue earned
($450 x 1/3)
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 Air & Sea T ravel
Work Sheet
For the M onth Ended April 30, 20x5
Unadjusted T rial Adjusted T rial
Account Balance Adjustments Balance
T itle Debit Credit Debit Credit Debit Credit
Cash 24,800 24,800
Accounts receivable 2,250 e. 250 2,500
Supplies 700 b. 300 400
Prepaid rent 3,000 a. 1000 2,000
Furniture 16,500 16,500
Accum depr, furn c. 275 275
Accounts payable 13,100 13,100
Salary payable d. 950 950
Income tax payable g. 540 540
Unearned svc rev. 450 f. 150 300
Common stock 20,000 20,000
Retained earnings 11,250 11,250
Dividends 3200 3,200
Service revenue $7,000 e. 250 $7,400
f. 150
Salary expense 950 d. 950 1,900
Rent expense a. 1000 1,000
Supplies expense b. 300 300
Depr. Exp, furn. c. 275 275
Utilities expense 400 400
Income tax expense g. 540 540
T otal $51,800 $51,800 3,465 3,465 53,815 53,815

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 Learning Objective 4
Prepare the financial statements.

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 Air & Sea Travel, Inc.
Income Statement
Month Ended April 30, 20x5

Revenue:
Service revenue $7,400
Expenses:
Salary expense $1,900
Rent expense 1,000
Utilities expense 400
Supplies expense 300
Depreciation expense 275 3,875
Income before tax $3,525
Income tax expense 540
Net income $2,985

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 Air & Sea Travel, Inc.
Statement of Retained Earnings
Month Ended April 30, 20x5

Retained earnings, April 1, 20x5 $11,250

Add: Net income 2,958
$14,235
Less: Dividends ( 3,200)
Retained earnings, April 30, 20x5 $11,035

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 Air & Sea Travel, Inc.
Balance Sheet
April 30, 20x5
Assets Liabilities
Cash $24,800 Accounts payable $13,100
Accounts receivable 2,500 Salary payable 950
Supplies 400 Unearned revenue 300
Prepaid rent 2,000 Income tax payable 540
Furniture $16,500 Total liabilities $14,890
Less: Stockholders’ Equity
Accumulated Common stock $20,000
depreciation ( 275) 16,225 Retained earnings 11,035
Total $31,031
Total liabilities and
Total assets $45,925 stockholders’ equity $45,925

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 Learning Objective 5
Close the books.

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 Closing Entries
• Prepare the accounts for the next period’s
transactions.
• Transfer the revenue, expense, and dividends
balances to Retained Earnings.

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 Which Accounts
Need To Be Closed?
• Temporary accounts are closed
– Revenue
– Expense
– Dividends
• Permanent accounts are not closed
– Assets
– Liabilities
– Stockholders’ equity
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 Journalizing the Closing Entries
General Journal
Date Accounts and Explanations PR Debit Credit
April 30 Service Revenue 7,400
Retained Earnings 7,400

April 30 Retained Earnings 4,415

Rent Expense 1,000
Salary Expense 1,900
Supplies Expense 300
Depreciation Expense 275
Utilities Expense 400
Income Tax Expense 540

April 30 Retained Earnings 3,200

Dividends 3,200
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 Posting the Closing Entries
Rent Expense Service Revenue
1,000 1,000 7,000
250
150
Salary Expense Retained Earnings 7,400 7,400
950 4,415 11,250
950 3,200 7,400
1,900 1,900 11,035

Other Expenses Dividends

1,515 1,515 3,200 3,200

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 Cash and Accrual Basis: Example

Johnson Company, a retailer, starts operations on

January 1, 2000, and reports the following information:
• Sales, $200,000 (20% cash and 80% credit)
• Accounts Receivable end of year: $16,000
• Purchases, $120,000 (30% cash and 70% credit)
• Accounts Payable end of year: $8,200
• Depreciation expense for 2000: $3,450
• Ending inventory of goods: $12,000
 Accrual Basis: Example
Sales Revenue:
Cash sales $ 40,000
Credit sales: 160,000
Net Sales $200,000
Cost of Goods Sold:
Purchases $ 120,000
less: Ending inventory 12,000 108,000

Gross Profit 92,000

Less: Depreciation Expense 3,450

Income Before Taxes $ 88,550

 Cash Basis
Cash Receipts:
Cash sales $ 40,000
Collections from credit sales:
Credit sales: $160,000
Less: Accounts. Receivable.: 16,000 144,000
Net Cash Revenue $184,000
Cash Payments:
Cash Purchases $ 36,000
Payments to vendors on account:
Credit purchases: $84,000
less: Accounts Payable: 8,200 75,800
Net Cash Expenses $ 111,800
Excess of Collections over Receipts $ 72,200
 Reconciliation of Cash and
Accrual Base Income

Accrual Base Income: $ 88,550

Add: Non-cash charge

Depreciation 3,450
92,000
Less: Uncollected revenue $16,000

Unpaid purchases 3,800 19,800

Excess of collections over payments $ 72,200

 Reconciling Cash Basis Receipts
with Accrual Revenue

Adjustments

- Beginning Accounts Receivable

Cash received + Ending Accounts Receivable Accrual
from Based
customers + Beginning Unearned Revenue Revenue
- Ending Unearned Revenue
 Reconciling Cash Basis Payments
with Accrual Expenses

Adjustments

Cash paid + Beginning Prepaid Expenses

- Ending Prepaid Expenses Accrual
for
Based
operating - Beginning Accrued Liabilities Expenses
expenses + Ending Accrued Liabilities
 Cash Basis Weaknesses
• Current economy is largely credit-based
• Information on future cash flow commitments
is crucial to investors and creditors
• Cash basis accounting does not provide
information on future cash flows