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Financial Accounting: A Business Process Approach Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-1 Chapter 3 Accruals and Deferrals: Timing Is Everything in Accounting Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-2 Learning Objectives When you are finished studying Chapter 3, you will be able to: 1. Define accrual accounting and explain how income is measured. 2. Explain accruals and how they affect financial statements; describe and perform the adjustments related to accruals. 3. Explain deferrals and how they affect financial statements; describe and perform the adjustments related to deferrals. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-3 Learning Objectives 4. Construct the basic financial statements from a given set of transactions that include accruals and deferrals and recognize the effect of these transactions on actual financial statements. 5. Compute and explain the profit margin on sales ratio. 6. Explain the business risks associated with financial records and accounting information. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-4 Ethics Matters Companies have been known to accrue revenue that does not exist. Archway Cookies needed to maintain its bank Archway Cookies was owned by a funding. private 1. Maintain equity stock firm prices. that was not Members of the equity firm, Catterton traded on private any stock exchange. Partners, and Archway Executives have been named in lawsuits from former employees and access distributors. 2. Maintain to bank funding. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-5 Learning Objective 1 Accrual Accounting Accrual Accounting: Recording the financial transactions of a business in the period in which they occur, rather than in the period in which cash is exchanged. The economic substance of the transaction signals the recording…not disbursing or receiving cash. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-6 Measuring Income The income statement summarizes revenues and expenses for a period of time, usually a year. Timing is everything in accounting. The lifenames of a business is income divided into discrete Other for the statement: periods of time - months, quarters, or years. • Statement of Operations •Revenue Statement of Earnings earned, not necessarily collected, in time or period be included on the •one Profit Lossmust (P&L) Statement income statement for that time period. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-7 Timing Differences . . . when revenues are earned and collected in different accounting periods. . . . when expenses are incurred in one period and paid for in another. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-8 Accruals Learning Objective 2 The action takes place before dollars are exchanged. Sales made on account Interest revenue Action first, cash payment later Purchases made on credit Interest expense Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-9 Adjustments for Accruals Accruals that need to be made before the financial statements are prepared are “adjustments to the books.” Revenue earned that has not been billed (no receivable has been recorded) Interest revenue that has been earned on loans that has not been recorded Expenses that have been incurred (used) but have not been recorded (salary expense) Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-10 Accruals Accounts Receivable: The amounts owed by customers for goods and services for sales on account, the most common accrual transaction. The revenue is recorded at the time of sale, but the cash for the sale will be collected later. Recording revenue with an increase in accounts receivable is called accruing revenue. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-11 Accruals Another common accrual is for interest— the cost of borrowing money. If money is borrowed, interest expense and interest payable (a liability) are recorded. If money is loaned, interest revenue and interest receivable (an asset) are recorded. Interest rates always pertain to one year. For loan periods of less than one year, interest will be due for a fraction of one year (6 months, 6/12). Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-12 Accruals for Interest On October 1, a company lends an employee $200 at 10% interest to be repaid on January 1 of the next year. When you lend money, the transaction decreases assets (cash) and increases assets (other accounts receivable). Total assets do not change. Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings (200) Cash +200 Other Receivables Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-13 Accruals for Interest Interest revenue is earned due to the passage of time. On December 31, the company will accrue interest revenue. (I)nterest = (P)rincipal X (R)ate X (T)ime $5 = $200 X .1 X 3/12 $5 = $200 X .10 X 3/12 The company earned $5 in interest revenue, but it has not received the cash. Assets and retained earnings both increase when the revenue and receivable are recorded. Assets = Liabilities + Shareholders’ Equity Contributed Capital +5 Interest Receivable Retained Earnings +5 Interest Revenue Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-14 Accruals Recognition of the event versus realization of cash. Recognizing a revenue or expense means to record it in the accounting records so that it appears on the income statement. Realized means the cash is collected. Sometimes revenue is recognized in one accounting period and realized in a different accounting period. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-15 Accruals When the company receives the interest payment on January 1, it will not be recorded as revenue. The revenue was recognized (recorded) on December 31. The cash will be realized (collected) and the asset account, cash, will increase. The interest receivable and other receivable asset accounts will decrease. Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings +205 Cash (200) Other Receivables (5) Interest Receivable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-16 Your Turn 3-1 Suppose your firm loaned an employee $1,000 at 7% (interest rates are always assumed to be per year) on July 1. On December 31, the firm is preparing its yearend financial statements. What adjustment would the firm need to make to properly account for any interest revenue that had been earned prior to year end? The firm has earned $35, six months’ worth of interest. The amount is ($1,000 X 0.07 X 6/12) = $35. The firm would accrue the interest revenue with an increase to revenue (retained earnings column of the accounting equation) and an increase to an asset, interest receivable. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-17 Accruals for Interest You borrow $500 from a bank on January 1, 2010 and agree to repay it with 8% interest on January 1, 2011. When you borrow money, the transaction increases assets (cash) and increases liabilities (notes payable). The accounting equation is increased on both sides. Assets = Liabilities + Shareholders’ Equity Contributed Capital +500 Cash Retained Earnings +500 notes payable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-18 Accruals for Interest $40 = $500 Interest Payable: the amount owed for borrowing money Assets = Liabilities X .08 Interest Expense: cost of using someone else’s money + Shareholders’ Equity Contributed Capital +40 Interest Payable X 1 (year) Retained Earnings (40) Interest Expense Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-19 Accruals for Interest No interest accrues in 2011, because you pay off the loan January 01, 2011. Assets decrease ($540 cash) and liabilities decrease ($40 Interest Payable and $500 Notes Payable). Assets = Liabilities + Shareholders’ Equity Contributed Capital (540) Cash Retained Earnings (500) notes payable (40) Interest Payable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-20 Accruals for Salaries A firm’s accounting period ends on Monday, December 31, 2012 and payday is every Friday. Employees earn $3,500 for a 5-day workweek. On December 31, one day’s salary expense is accrued. Salary expense = 3,500/5= 700 per day X 1 day = 700. Assets = Liabilities + Shareholders’ Equity Contributed Capital 700 Salaries Payable Retained Earnings (700) Salary Expense Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-21 Accruals for Salaries On January 4, employees will be paid for the entire week. How much salary expense is recorded for work done in 2013? Salary expense = $3,500/5= 700 per day X 4 days = $2,800. Assets = Liabilities +Shareholders’ Equity Contributed Capital (3,500) cash Retained Earnings (700) Salaries Payable Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall (2,800) salary expense 3-22 Your Turn 3-2 Suppose ABC Company pays its employees a total of $56,000 on the 15th of each month for work done the previous month. ABC generally records salary expense when the employees are paid. If the ABC fiscal year end is June 30, 2010, does any salary expense need to be accrued at year end? If so, how much? Yes, salary expense needs to be accrued. The expense for June would routinely be recorded on July 15 when the payment is made. To get the June salary expense on the income statement for the year ended June 30, ABC Company needs to accrue the expense. A month of salary expense for June is recorded as salary expense and salaries payable in the amount of $56,000. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-23 Learning Objective 3 Deferrals A deferral occurs when cash is received or paid before revenue is earned or an expense is incurred. Defer means to “put off or postpone.” Dollars first, action later Unearned Revenue Prepaid expenses Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-24 Deferred Revenue The company does not ship magazines until a customer’s payment is received. The company receives a check for $60 for a twelve-month subscription. Revenue is not recognized until the magazines are delivered...but the company must record the fact that it has received the cash. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-25 Deferred Revenue Unearned revenue is a liability that represents the amount of goods or services a company owes to its customers. Cash has been collected, but revenue is not earned until purchased items are shipped. Assets = Liabilities + Shareholders’ Equity Contributed Capital +60 cash Retained Earnings +60 Unearned Revenue Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-26 Deferred Revenue When the magazines sold are actually shipped, the company recognizes the revenue. Assets = Liabilities + Shareholders’ Equity Contributed Capital (5) Unearned Revenue Retained Earnings + 5 Revenue Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-27 Deferred Expenses You’ve paid the cash “up-front” but you haven’t received the goods or services yet. Prepaid Expenses Insurance Rent Supplies Remember: DEFER means to postpone. Here, we postpone recognizing the expense until we actually use the goods or services. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-28 Prepaid Insurance Companies pay insurance in advance. When the cash is paid, the company has purchased an asset called prepaid insurance. On Oct. 01, the company paid $2,400 for one year’s insurance coverage. Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings (2,400) cash 2,400 Prepaid insurance Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-29 Prepaid Insurance The passing of time signals the insurance is being used. On Dec. 31st, an expense is recognized when the company actually uses the insurance. Assets = Liabilities + Shareholders’ Equity Contributed Capital (600) Prepaid insurance Retained Earnings (600) Insurance expense Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-30 Prepaid Rent Companies pay rent in advance. When the cash is paid, the company has purchased an asset called prepaid rent. On November 1, the company paid $9,000 for three months’ rent in advance. Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings (9,000) Cash + 9,000 Prepaid Rent Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-31 Prepaid Rent The passing of time is the action that signals recognition of the expense. The financial statements are prepared on December 31. Assets = Liabilities + Shareholders’ Equity Contributed Capital (6,000) Prepaid Rent Retained Earnings (6,000) Rent Expense Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-32 Supplies A company paid $500 cash for supplies during the month. Supplies are recorded as an asset when purchased. Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings (500) Cash +500 Supplies Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-33 Supplies Supplies are recognized as an expense after they are used. At the end of the month, $150 worth of supplies are on hand. Assets = Liabilities + Shareholders’ Equity Contributed Capital (350) Supplies Retained Earnings (350) Supplies Expense Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-34 Deferred Expenses A special deferral—depreciation: Recognizing an expenditure by spreading it over several years, allocating a part of the expense to each of several periods during which the asset is used. When a company buys an asset that is used up in the business AND it will be useful for more than one year, GAAP says that the expense must be spread over the accounting periods during the useful life of the asset. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-35 Depreciation Suppose a company bought a computer for $5,000 cash. The asset is expected to last five years and have no residual value at the end of its useful life. How will the purchase of the asset affect the financial statements? Assets = Liabilities + Shareholders’ Equity Contributed Capital Retained Earnings (5,000) Cash +5,000 Computer Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-36 Depreciation Expense DEPRECIATION EXPENSE: The portion of the cost of an asset allocated to any one accounting period. Accumulated Depreciation: Total depreciation expense taken over the entire life of the asset (a contra-asset account). To depreciate the computer using the STRAIGHT LINE method: Divide the cost of the asset (minus any estimated residual value) by its useful life: Cost – Residual Value Estimated Useful Life Annual depreciation expense and accumulated depreciation for the computer is: $5,000/5 = $1,000 each year Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-37 Depreciation Expense How will the use of the asset affect the financial statements? Each year for five years, the computer’s book value will be reduced on the balance sheet by $1,000. Each year for five years, an expense of $1,000 will be recognized on the income statement. Assets = Liabilities + Shareholders’ Equity Contributed Capital (1,000) Accumulated Depreciation Retained Earnings (1,000) Depreciation Expense Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-38 Learning Objective 4 Accounting Equation Transactions for Team Shirts for March 2010 Assets = Liabilities + Shareholders' Equity Contributed Capital Beginning Balances All other Assets 150 100 125 Cash 6,695 (Account) = All Liabilities (Account) Accounts Receivable 800 Accounts Payable Inventory 50 Other Payable Prepaid Insurance + Retained Earnings + Common Stock Account 5,000 1,220 Transactions 1 2 (1,000) (50) 4,000 3 4 150 (800) (150) 5 6 (1,000) 1,000 2,000 Inventory Accounts Receivable (800) Notes Payable Other Payables (800) Accounts Payable + + + (100) + (50) Computer 3,000 Accounts Receivable Adjustment 1 (100) Inventory Accumulated Depreciation Adjustment 2 (50) Prepaid Insurance + 2,000 (800) Adjustment 3 Ending Balances (50) + + + 30 3,995 + 6,275 = 3,030 Interest Payable (30) + 5,000 + Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall Sales Cost of Goods Sold Depreciation Expense Insurance Expense Interest Expense 2,240 3-39 Accounting Equation Preparing Team Shirts’ Financial Statements 1. The income statement is prepared first. 2. Net income can be used on the statement of changes in shareholder’s equity. 3. The total contributed capital and retained earnings from that statement are then used on the balance sheet. 4. Finally, the cash transactions are reorganized and summarized for the statement of cash flows. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-40 Learning Objective 5 Ratio Analysis Profit Margin measures how much of the firm’s sales revenue actually makes its way to the bottom line – net income. Hormel Foods Corporation profit margin for fiscal year ending 10/28/2007: Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-41 Your Turn 3-7 Use the following information from Campbell Soup Company’s income statements to calculate the company’s profit margin on sales ratio. How does it compare with the ones calculated for Hormel? For the year ended August 3, 2008 Net sales $7,998 Net income $1,165 For the year ended July 29, 2007 $7,385 $ 854 For 2008: $1,165 ÷ $7,998 = 14.57% For 2007: $ 854 ÷ $7,385 = 11.56% The profit margin on sales ratio is growing, which is a good thing. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-42 Learning Objective 6 Business Risk, Control, and Ethics Three significant risks associated with financial information: 1. Errors in recording and updating the accounting records. 2. Unauthorized access to the accounting records. 3. Loss of the data in the accounting records. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-43 Learning Objective 6 Business Risk, Control, and Ethics The controls that can minimize these risks: 1. Input and processing controls are designed to make sure that only authorized transactions are put into the system. 2. Reconciliation and control reports are designed to catch any errors in the input and processing of the accounting data. 3. Documentation controls that provide supporting evidence for the recorded transactions are designed to keep errors from occurring and to catch errors that have occurred. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-44 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 3-45