Chapter Three Outline
Chapter Three Outline ACG2021
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This 5 page Class Notes was uploaded by Nicholas D'Ambrosio on Sunday September 11, 2016. The Class Notes belongs to ACG2021 at University of Florida taught by Jill Kristen Goslinga in Fall 2016. Since its upload, it has received 16 views. For similar materials see Introduction to Financial Accounting in Finance at University of Florida.
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Date Created: 09/11/16
Chapter Three: Accrual Accounting & Income III. Accrual Accounting & Income A. Explain How Accrual Accounting Differs from Cash Basis Accounting Accrual accounting records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the accountant records the transaction, even if the business receives or pays no cash. Cash-basis accounting records only cash transactions. Cash receipts are treated as revenues, and cash payments are handled as expenses. Generally Accepted Accounting Principles (GAAP) Require Accrual Accounting 1. Accrual Accounting and Cash Flows Most accurate form of accounting, for this form takes into account all cash transactions as well as all noncash transactions. 2. The Time-Period Concept Companies need regular progress reports to measure income. The Time-Period Concept ensures that accounting information is reported at regular intervals. Companies prepare financial statements annually as well as quarterly or after each period. B. Apply the Revenue and Expense Recognition Principles 1. The Revenue Principle The Revenue Principle deals with two issues: - When to record (recognize) revenue - What amount of revenue to record Revenue should be recorded after it has been earned, not before. 2. The Expense Recognition Principle The Expense Recognition Principle is the basis for recording expenses. It includes two steps: - Identify all the expenses incurred during the accounting period. - Measure the expenses and recognize them in the same period in which any related revenues are earned. To recognize expenses along with related revenues means to subtract expenses from related revenue to compute net income or net loss. C. Adjust the Accounts 1. Categories of Adjusting Entries Accounting adjustments fall into three basic categories: deferrals, depreciation, and accruals. a. Deferrals A deferral is an adjustment for a payment of an item or receipt of cash in advance. There is also deferral adjustments on liabilities. When a company receives cash up front, it has a liability to provide a service to the customer. This liability is called Unearned (or deferred) Service Revenue. Then when the service is completed the company earns service revenue. b. Depreciation Depreciation allocates the cost of a plant asset to expense over the asset’s useful life. Depreciation is the most common long term deferral. Wear and tear. c. Accruals An accrual is the opposite of a deferral. For an accrued expense, a company records the expense before paying cash. For an accrued revenue, a company records the revenue before collecting cash. An accrued revenue is a revenue that the business has earned and will collect next year. The adjustment debits a receivable and credits a revenue. 2. Prepaid Expenses A prepaid expense is an expense paid in advance. Therefore prepaid expenses are assets because they provide a future benefit for the owner. 3. Depreciation of Plant Assets Plant assets are long lived tangible assets, such as land, buildings, furniture, and equipment. All plant assets except land decline in usefulness, and this decline is an expense. Depreciation is the process of allocating cost to expense for a long term plant asset. Straight line depreciation method: cost of asset / expected useful life. The Accumulated Depreciation account shows the sum of all depreciation expense from using the asset. Therefore, the balance in the accumulated depreciation account increases over the asset’s life. Accumulated depreciation is a contra account -an asset account with a normal credit balance. A contra account has two distinguishing characteristics: -It always has a companion account. -Its normal balance is the opposite that of the companion account. The net amount of a plant asset (cost minus depreciation) is called that asset’s book value. 4. Accrued Expenses The term accrued expenses refers to a liability that arises from an expense that has not yet been paid. Companies record accrued expenses at the end of each period. 5. Accrued Revenues A revenue that has been earned but not yet collected is called an accrued revenue. 6. Unearned Revenues Collecting cash from customers before earning revenue is referred to as a liability called unearned revenue. 7. Summary of the Adjusting Process Two purposes of the adjusting process are to: - Measure income and - Update the balance sheet. Therefore, adjusting every entry affects both of the following: - Revenue or expense- to measure income. - Asset or liability- to update the balance sheet. 8. The Adjusted Trial Balance A useful step in preparing the financial statements is to list the accounts, along with their adjusted balances, on an adjusted trial balance. D. Construct the Financial Statements All financial statements can be constructed from looking at the adjusted trial balance. E. Closing the Books At the end of each accounting period it’s necessary to close the books, in order to make an accurate measurement of revenue, expenses, and dividends for that period before proceeding to the next. The closing entries set the revenue, expense, and dividends balances back to zero at the end of the period. 1. Temporary Accounts Because revenues, expenses, and dividends relate to a limited period, they are called temporary accounts. The closing process applies only to temporary accounts. 2. Permanent Accounts Permanent accounts include assets, liabilities, and stockholder’s equity. They are not closed at the end of the period, for they carry over to the next period. Here are the steps to close the books of a company: - Debit each revenue account for the amount of its credit balance. Credit retained earnings for the sum of the revenues. This process transfers the sum of all revenues into Retained Earnings, therefore increasing retained earnings. - Credit each expense account for the amount of its debit balance. Debit retained earnings for the sum of the expenses. This process transfers the sum of the expenses into retained earnings, therefore decreasing retained earnings. - Credit the dividends account for the amount of its debit balance. Debit retained earnings. This entry places the dividends amount in the debit side of retained earnings. Remember that dividends are not expenses, but represent a permanent reduction of retained earnings. 3. Classifying Assets and Liabilities Based on Their Liquidity Liquidity measures how quickly an asset can be converted to cash. a. Current Assets Current assets are the most liquid. They will be converted to cash, sold, or consumed within the next 12 months. The operating cycle is the time span during which cash is paid for goods and services, and these goods and services are sold to bring in cash. b. Long Term Assets Long term assets are all assets that are not classified as short term. c. Current Liabilities Debts that must be paid within one year after the balance sheet. Liabilities are reported in order of the date they have to be paid, soonest to latest. d. Long Term Liabilities Any liabilities that are not current liabilities. Many long term liabilities are paid off in installments. The first installment would be a current asset and the remainder a long term asset. 4. Formats for the Financial Statements Companies can format their financial statements in different ways. Both the balance sheet and the income statement can be formatted in two basic ways: a. Balance-Sheet Formats The Report Format lists the assets at the top, followed by the liabilities and stockholder’s equity below. About 60% of large companies use this format. The Account Format lists assets on the left side and liabilities and stockholder’s equity on the right, very similar to the T account. b. Income Statement Formats A single step income statement lists all the revenues together under a heading such as Revenues. The expenses are all listed together under a heading such as Expenses. Therefore, the only step to finding net income or loss is to subtract expenses from revenue. A multistep income statement reports a number of subtotals to highlight important relationships between revenues and expenses. This method shows things like gross profit, which can be very valuable to large companies. F. Analyze and Evaluate a Company’s Debt Paying Ability 1. Net Working Capital Net working capital is computational data that represents operating liquidity. Net Working Capital = Total Current Assets – Total Current Liabilities Successful companies have a high net working capital. 2. Current Ratio Another measure of liquidity is the current ratio. Total Current Assets Current Ratio = Total Current Liabilities Successful companies have high current ratios. A strong current ratio is 1.5, successful business are usually between 1.5 and 2, and a current ratio less than 1 is considered low. 3. Debt Ratio Total Liabilities Debt Ratio = Total Assets The norm for debt ratios for most big companies ranges from 60% - 70%. To keep debt ratios within normal limits, companies use these strategies: - Increase revenue and decrease costs, thus increasing current assets, net income, and retained earnings without increasing liabilities. - Sell stock, thus increasing cash and stockholder’s equity. - Choose to borrow less money.
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