Accrual Accounting and Financial Statements PDF

Accrual Accounting and the Financial Statements CHAPTER 3 1  Revenue and Matching Principles Illustrated Green is for Seller, Red is for Buyer...

Accrual Accounting and the Financial Statements CHAPTER 3 1  Revenue and Matching Principles Illustrated Green is for Seller, Red is for Buyer Services Provided or Received? Yes No Cash Asset inc Cash received or paid in advance? Cash Asset inc Service Revenue SE inc Unearned Revenue Yes Liability inc Expense SE dec Prepaid Expense Asset inc Cash Asset dec Cash Asset dec (Not an Accrual or Prepayment) (Prepayments or Deferrals) Accounts Receivable (A/R) Asset inc Service Revenue SE inc Expense SE dec No Not a transaction Accounts Payable (A/P) (or another liability) Liability inc (Accruals) 1-2 Accrual vs. Cash-Basis Accounting ACCRUAL ACCOUNTING CASH-BASIS ACCOUNTING Records impact of transactions when Records only cash transactions they occur ◦ Cash receipts Required by IFRS and ASPE ◦ Cash payments Records: Ignores important information ◦ Revenue when earned Results in incomplete financial ◦ Expenses when incurred statements 1-3  Accrual Accounting Records both cash and noncash transactions Cash transactions Noncash transactions Collecting payments from Sales on account customers Receiving interest earned Purchases on account Borrowing money Accrual of expenses not yet paid Paying expenses Depreciation expense Paying off loans Usage of prepaid expenses Issuing shares Earning of revenue when cash was collected in advance 1-4 Revenue Recognition Principle WHEN TO RECORD AMOUNT TO RECORD After revenue is earned: Cash value of goods or services transferred to customer When good or service has been delivered to customer 1-5 Adjustments and the Conceptual Framework Adjustments are end-of-year journal entries to update account balances Going-concern and periodicity dictate that financial statements be prepared periodically Faithful representation requires updating account balances 1-6 Stelco Example Attempt to increase Sales in the Construction Industry… 1-7 Why Adjusting Entries? Accrual basis, not cash basis ◦ With cash basis, there is no need for adjusting entries Timing differences between cash and performance Long-term assets 1-8 Categories of Adjustments Deferrals Depreciation Accruals 1-9  Deferrals Business has paid or received cash in advance Prepaid expense Unearned revenue Recorded as an asset when purchased Recorded as a liability when payment is received Expensed when used or expired Recorded as revenue when earned 1-10 Depreciation Allocates cost of plant assets to expense over useful lives Represents wear-and-tear and obsolescence Examples of plant assets: ◦ Buildings ◦ Equipment ◦ Furniture 1-11 Accruals ACCRUED EXPENSES ACCRUED REVENUES Record expense before paying cash Record revenue before collecting cash Salaries, interest, and income taxes Earned and will collect next period 1-12 The Need for Adjusting Entries: An Example On March 1, 2017 a company pays $12,000 for one year’s rent The Journal Entry: March 1, 2017 Prepaid Rent 12,000 Cash 12,000 Dr. Prepaid Rent Cr Dr. Cash Cr.. 3/1 12,000 3/1 12,000 1-13 What is the adjusting Entry on Dec 31st? Answer on Poll: A.Dr Rent Expense 12,000 and CR Prepaid Rent 12,000 B. Dr Rent Expense 12,000 and Cr Cash 12,000 C. Dr. Rent Expense 10,000 and Cr Prepaid Rent 10,000 D.Dr Rent Expense 10,000 and Cr Cash 10,000 E. Dr. Rent Expense 2000 and Cr Prepaid Rent 2,000 1-14 What is the adjusting Entry on Dec 31st? Answer on Poll: A.Dr Rent Expense 12,000 and CR Prepaid Rent 12,000 B. Dr Rent Expense 12,000 and Cr Cash 12,000 C. Dr. Rent Expense 10,000 and Cr Prepaid Rent 10,000 D.Dr Rent Expense 10,000 and Cr Cash 10,000 E. Dr. Rent Expense 2000 and Cr Prepaid Rent 2,000 1-15 What is the adjusting Entry on Dec 31st? By December 31, 2017, the firm would have occupied the property for 10 months. Also, there are only two months left in Prepaid Rent: Monthly rent = 12,000 / 12 = $1,000 Rent expense for 2017 = 1,000 x 10 = $10,000 Prepaid rent as of 12/31/2017 = 1,000 x 2 = $2,000 But so far, prepaid rent has a balance of $12,000 and rent expense is not recorded yet 1-16 Why Adjusting Entries? T-accounts of prepaid rent and rent expense should have ending balances of $2,000 and $10,000, respectively Dr. Prepaid Rent Cr. Dr. Rent exp Cr. 3/1 12,000 12/31 10,000 12/31 10,000 Bal. 2,000 Bal. 10,000 Thus, the adjusting entry would be: 12/31/2017 Rent expense 10,000 Prepaid rent 10,000 1-17 Prepayments (Deferrals) Result when: ◦ Cash advance is received to provide future services (unearned revenue) ◦ Adjustment is made when revenue is earned ◦ Cash advance is paid to receive future services (prepaid expenses) ◦ Adjustment is made when the services are received ◦ Amortizing long-term assets and expensing supplies are a special cases of prepayments 1-18 Prepayments- Example 1 On March 1, 2016, XYZ Co. purchased an insurance policy for one year effective immediately. The premium of $2,400 is paid in advance. The accounting period is 12 months ending December 31 of each year. 2016 is the first year of operation for XYZ. In March 1, 2017 XYZ renewed the insurance policy. The new premium of $3,000 is paid in advance. 1-19 Example 1- 2016 03/01/2016 Prepaid insurance 2,400 Cash 2,400 On December 31, 2016: Insurance Expense = 2,400/12 X 10 = $2,000 12/31/2016 Insurance Expense 2,000 Prepaid Insurance 2,000 Prepaid Dr. insurance Cr. Dr. Insurance exp Cr. 03/01 2,400 12/31 2,000 12/31 2,000 Bal. 400 Bal. 2,000 1-20 Example 1- 2017 03/01/2017 Prepaid insurance 3,000 Cash 3,000 What is the adjusting entry on December 31, 2017? Answer on Polling: A. Dr Insurance Exp 2900 and Cr Prepaid Ins 2900 B. Dr Insurance Exp 2600 and Cr Prepaid Ins 2600 C. Dr Insurance Exp 3000 and Cr Prepaid Ins 3000 D. Dr Cash 3000 and Cr Prepaid Ins 3000 E. Dr Cash 2600 and Cr Prepaid Ins 2600 1-21 Example 1- 2017 03/01/2017 Prepaid insurance 3,000 Cash 3,000 What is the adjusting entry on December 31, 2017? Answer on Polling: A. Dr Insurance Exp 2900 and Cr Prepaid Ins 2900 B. Dr Insurance Exp 2600 and Cr Prepaid Ins 2600 C. Dr Insurance Exp 3000 and Cr Prepaid Ins 3000 D. Dr Cash 3000 and Cr Prepaid Ins 3000 E. Dr Cash 2600 and Cr Prepaid Ins 2600 1-22 Example 1- 2017 03/01/2017 Prepaid insurance 3,000 Cash 3,000 On December 31, 2017: Insurance Expense: Used From old policy = 2,400/12 X 2 = $400 used in Jan and Feb of 2017 Used From new policy = 3,000 / 12 X 10 = $2,500 used from Mar to Dec 2017 Insurance expense = 400 + 2,500 = $2,900 total for Jan to Dec 2017 12/31/2017 Insurance Expense 2,900 Prepaid Insurance 2,900 Prepaid Dr. insurance Cr. Dr. Insurance exp Cr. Bal. 400 12/31 2,900 03/01 3,000 12/31 2,900 Bal. 500 Bal. 2,900 1-23 Prepayments- Example 2 On March 1, 2017 XYZ buys office supplies for $3,000. On December 31, 2017 physical counts shows supplies on hand of $1,200 1-24 03/01/2017 Supplies 3,000 Cash 3,000 On December 31, 2017 Ending supplies = Beginning Supplies + Purchases – Supplies Expense 1,200 = 0 + 3,000 – Supplies Expense → Supplies Expense = $1,800 12/31/2017 Supplies Expense 1,800 Supplies 1,800 Dr. Supplies Cr. Dr. Supplies Expense Cr. Beg. Bal. 0 12/31 1,800 12/31 1,800 03/01 3,000 Bal. 1,800 Bal. 1,200  Prepayments- Example 3 On April 1, 2017 ABC purchased equipment that cost $80,000. The expected useful life is 4 years and the estimated salvage value at the end of its life is $20,000. The company uses Straight-Line depreciation method. The accounting period ends Dec. 31 each year. 04/01/2017 Equipment 80,000 Cash 80,000 Annual Depreciation Expense = (Cost – Salvage Value) / Useful Life Depreciation Expense for 2017 = (80,000-20,000)/4 X 9/12 = $11,250 12/31/2017 Depreciation Expense 11,250 Accumulated Depreciation- Equipment 11,250 CONTRA ASSET 1-26  Prepayments- Example 3 On April 1, 2017 ABC purchased equipment that cost $80,000. The expected useful life is 4 years and the estimated salvage value at the end of its life is $20,000. The company uses Straight-Line depreciation method. The accounting period ends Dec. 31 each year. What is the impact on Assets, Liability, SE and NI if ABC neglects to enter the adjusting entry? A. Understated: Assets, Overstated: SE, NI No Impact: Liability B. Overstated: SE, NI and No Impact: Assets, Liability C. Understated: Liability, and Overstated: Assets, SE, NI D. Overstated: Assets, SE, NI No Impact: Liability E. Understated: Assets, SE, NI and No Impact: Liability 1-27  Prepayments- Example 3 On April 1, 2017 ABC purchased equipment that cost $80,000. The expected useful life is 4 years and the estimated salvage value at the end of its life is $20,000. The company uses Straight-Line depreciation method. The accounting period ends Dec. 31 each year. What is the impact on Assets, Liability, SE and NI if ABC neglects to enter the adjusting entry? A. Understated: Assets, Overstated: SE, NI No Impact: Liability B. Overstated: SE, NI and No Impact: Assets, Liability C. Understated: Liability, and Overstated: Assets, SE, NI D. Overstated: Assets, SE, NI No Impact: Liability E. Understated: Assets, SE, NI and No Impact: Liability 1-28 Depreciation, Book Value, Expense, Gain/Loss Explained… Truck Purchase Example 1-29 Prepayments- Example 4 On June 1, 2017 ABC Publishers Inc., receives $36,000 in newspaper subscriptions for the next year, effective August 1, 2017. Prepare the adjusting entry as of December 31, 2017. 1-30 Aug/01/2017 Cash 36,000 Unearned Revenue 36,000 On December 31, 2017: Revenue for 2017 = 36,000/12 X 5 = $15,000 earned from Aug to December 12/31/2017 Unearned Revenue 15,000 Revenue 15,000 Unearned Dr. Revenue Cr Dr. Revenue Cr.. Beg. Bal. 0 08/01 36,000 12/31 15,000 12/31 15,000 Bal. 21,000 Bal. 15,000 Accruals Accrued expenses (unrecorded expenses): Expenses incurred but not yet paid in cash or recorded until the end of period Accrued revenues (unrecorded revenues): Revenues earned during the period but not yet received in cash or recorded until the end of period 1-32 Accruals- Example 1 If ABC’s 5-day weekly payroll was $6,000, and the year ended on a Wednesday. ABC pays and records wages each Friday. Prepare the adjusting entry as of fiscal year end. Prepare the adjusting entry required on December 31, 2018, if any. 1-33 Daily wages expense = 6,000 / 5 = $1,200 Monday Tuesday Wednesday Thursday Friday $1,200 $1,200 $1,200 $1,200 $1,200 Year-End Pay Day On Wednesday: Salaries Expense = 6,000/5 X 3 = $3,600 Salaries Expense 3,600 Salaries Payable 3,600 On Friday: Salaries Payable 3,600 Salaries Expense 2,400 Cash 6,000 Accruals- Example 2 On September 1, 2017, ABC put $10,000 in a saving account for one year. The interest rate is 12% receivable every six months, on March 1 and September 1. Prepare the adjusting entry on Dec. 31, 2017. 1-35 Interest Revenue = Principal x Interest Rate x Period Interest Revenue for 2017 = 10,000 x 12% x (4/12) = $400 Interest rates are always annual. Adjusting entry on 12/31/2017: Interest Receivable 400 Interest Revenue 400 Ethical Issues in Accrual Accounting “Managing” earnings to meet or beat Bay Street forecasts. Questionable timing of recognizing revenues, and expenses; affects quality of earnings. Cookie jar reserves for discretionary expenses and liabilities 1-37 Closing the Books Prepares the accounts for next period Sets revenues, expenses, and dividends to zero 1-38 Closing the Books Temporary Permanent Accounts Accounts Closed Not closed Revenues, Assets, expenses, liabilities, and and dividends equity 1-39 Closing Entries Close Revenues Debit each revenue account Credit Retained earnings Close Expenses Debit Retained earnings Credit each expense account Close Dividends Debit Retained earnings Credit Dividends 1-40 Balance Sheet Formats REPORT FORMAT ACCOUNT FORMAT Assets listed at the top Assets on the left Start with current assets and Start with current assets and within current assets list in within current assets list in order of liquidity order of liquidity Liabilities and equity beneath Liabilities and equity on the right 1-41 Income Statement Formats SINGLE-STEP MULTI-STEP All revenues grouped together Shows subtotals to emphasize relationships All expenses grouped together Includes ◦ Gross profit ◦ Income from operations ◦ Income before taxes ◦ Net income 1-42 Ratios Liquidity Solvency Profitability 1-43 Liquidity: Net Working Capital Current Current assets liabilities 1-44 Liquidity: Current Ratio Current assets Current liabilities Measures ability to pay current liabilities Strong current ratio = 1.50?? 1-45 Solvency: Debt Ratio Total liabilities Total assets Measures ability to pay all liabilities Low debt ratio is safer than high debt ratio 1-46  Ratio Question 1 The following information is available for three companies in the same industry: A B C Current Assets $100,000 $150,000 $200,000 Total Assets $250,000 $400,000 $500,000 Current Liabilities $ 50,000 $90,000 $125,000 Total Liabilities $200,000 $200,000 $300,000 Revenues $800,000 $800,000 $800,000 Net Income $500,000 $400,000 $300,000 1. List in order, which one has the best ability to meet its short-term obligations? a. A, B, C b. B, A, C c. C, B, A d. None of the above e. Cannot be determined from the information given 1-47  Ratio Question The following information is available for three companies in the same industry: A B C Current Assets $100,000 $150,000 $200,000 Total Assets $250,000 $400,000 $500,000 Current Liabilities $ 50,000 $90,000 $125,000 Total Liabilities $200,000 $200,000 $300,000 Revenues $800,000 $800,000 $800,000 Net Income $500,000 $400,000 $300,000 1. List in order, which one has the best ability to meet its short-term obligations? a. A, B, C b. B, A, C c. C, B, A d. None of the above e. Cannot be determined from the information given SOLUTION = LIQUIDITY IS CURRENT RATIO A = 100/50 = 2, B= 150/90 = 1.67, C= 200/125 = 1.60 ANSWER IS a 1-48  Ratio Question 2 The following information is available for three companies in the same industry: A B C Current Assets $100,000 $150,000 $200,000 Total Assets $250,000 $400,000 $500,000 Current Liabilities $ 50,000 $90,000 $125,000 Total Liabilities $200,000 $200,000 $300,000 Revenues $800,000 $800,000 $800,000 Net Income $500,000 $400,000 $300,000 2. List in order, which one is most likely to file for bankruptcy? a. A, B, C b. B, C, A c. A, C, B d. None of the above e. Cannot be determined from the information given 1-49  Ratio Question 2 The following information is available for three companies in the same industry: A B C Current Assets $100,000 $150,000 $200,000 Total Assets $250,000 $400,000 $500,000 Current Liabilities $ 50,000 $90,000 $125,000 Total Liabilities $200,000 $200,000 $300,000 Revenues $800,000 $800,000 $800,000 Net Income $500,000 $400,000 $300,000 2. List in order, which one is most likely to file for bankruptcy? a. A, B, C b. B, C, A c. A, C, B d. None of the above e. Cannot be determined from the information given SOLUTION = SOLVENCY IS DEBT RATIO A= 200/250 = 0.8, B=200/400 = 0.5, C= 300/500 = 0.6 ANSWER IS c 1-50 Effect of Transactions on Ratios What is the Impact on the Current Ratio and Debt Ratio for the following transactions? Issue Shares to Raise Cash Pay Cash to Purchase Building Collect Accounts Receivable Accrued Expenses Record Depreciation Cash Sales Borrow Funds on Loan 1-51 Homework – Try the Adjusting Entry Questions from Midterm Practice 1-52 End Chapter 3 1-53