Accrual Accounting By P Raghava Narayana Chartered Accountant

Accrual Accounting By P. Raghava Narayana Chartered Accountant 1

Accrual vs. Cash-Basis Accounting CASH • Records transactions only when cash is received or paid ACCRUAL • Records business transactions when they occur § When customer pays for product or service § When bills are paid § When sale is made § When bill is received • Complies with GAAP • Presents accurate financial picture • Only used by very small businesses • Omits important info 2.

Accrual Accounting and Cash Flows • Accrual accounting records both cash and non-cash transactions Cash Collecting from customers Paying for expenses Borrowing money Issuing Shares Non-cash Sales on credit Purchases on credit Using prepaid expenses, such as supplies 3

Time-Period Concept • Businesses do not stop operations to measure financial transactions • Accountants prepare financial statements at regular intervals to measure performance • Companies select a twelve-month period for reporting purposes: § Calendar year § Fiscal year 4

The Revenue Principle • Revenue is recorded when earned § When product or service is delivered to customer § Cash may come before, at the same time, or after delivery • Revenue is recorded at the cash value of goods or services provided 5

The Matching Principle • Expenses are incurred to help produce revenue • Expenses should be recorded in the time period in which they are incurred • Expenses should be matched to the revenues they help produce EXPENSES REVENUES 6

Expenses • May be paid in cash § Paying monthly rent • May arise from using up an asset § Using supplies previously purchased • May arise from creating a liability § Receive a bill from a supplier 7

ILLUSTRATION • During the financial year 2010 -11, Ashok had cash sales of Rs. 3, 90, 000 and credit sales of Rs. 1, 60, 000. • His expenses for the year were Rs. 2, 70, 000 out of which Rs. 80, 000 is still to be paid. • Find out Ashok's income for 2010 -11 following the Cash Basis of Accounting. 8

The Adjustment Process • At the end of the period, a business prepares financial statements • Ensures that: § All revenue that has been earned has been recorded § All expenses that have been incurred are matched to revenues § Asset and liability accounts are up-to-date 9

Categories of Adjusting Entries • Deferrals • Depreciation • Accruals 3 -10

Deferrals • Cash has already been received or paid § Related expense or revenue has not yet been recorded • Prepaid expenses § Company has paid for expense in advance § Adjustment needed to record amount used • Unearned revenues § Customer pays in advance for good or service § Adjustment needed to record amount of revenue earned 11

Prepaid Expenses • • Expenses paid in advance Include prepaid rent and supplies Asset is recorded when purchased Adjustment needed to record amount used 12

Prepaid Rent Example • Suppose on April 1 on a company paid Rs. 12, 000 for one year’s rent in advance JOURNAL Date Accounts 1 -Apr Prepaid rent Debit Credit Rs. 12, 000 Cash Rs. 12, 000 13

Prepaid Rent Example • Now, it’s December 31 and assume that the company is closing its book on December 31. • The amount of rent that has expired must be recorded • This amount is recorded as rent expense • Prepaid rent (asset) needs to be reduced so it reflects the amount of rent remaining 14

Rs. 12, 000 Prepaid Rent Rs. 9, 000 April 1, current year April 1 to December 31 = 9 months Rs. 3, 000 December 31 April 1, following year 3 out of 12 months of rent remains 9 out of 12 months of rent has expired 9/12 x Rs. 12, 000 = Rs. 9, 000 3/12 x Rs. 12, 000 = Rs. 3, 000 15

Prepaid Rent Example • Dec 31 – Adjust Prepaid Rent account for amount expired JOURNAL Date Accounts 31/12 Rent Expense Debit Credit Rs. 9, 000 Prepaid Rent Rs. 9, 000 16

Prepaid Rent Apr 1 Rs. 12, 000 Dec 31 Rs. 9, 000 Represents amount expired Rs. 3, 000 End-of-year balance Rent Expense Represents amount remaining 17

Supplies Example • Suppose a company purchased Rs. 3, 200 of supplies during the year § The asset “supplies” was debited for each purchase • At the end of the year, a physical count reveals Rs. 500 of supplies on hand 18

Supplies Example Supplies Balance per ledger Rs. 3, 200 What amount of supplies was used? Balance per physical count Rs. 500 Subtract the balance per count from the balance per ledger 19

Supplies Example • Dec 31 – Adjust Supplies account for amount used JOURNAL Date Accounts 31/12 Supplies Expense Debit Credit Rs. 2, 700 Supplies Rs. 2, 700 20

Supplies Rs. 3, 200 Dec 31 Rs. 2, 700 Dec 31 Rs. 2, 700 Represents amount used Rs. 500 End-of-year balance Supplies Expense Represents amount on hand 21

Depreciation of Plant Assets • Allocation of plant assets cost over their useful lives • Results in a debit to an expense § Depreciation Expense • Corresponding credit § Accumulated Depreciation 22

Accumulated Depreciation • Account that shows the sum of depreciation expense of the plant asset • Contra-asset § Always has a companion account § Normal credit balance 23

Depreciation Example • A company purchases equipment for Rs. 50, 000 • The estimated useful life of the equipment is five years 50, 000/5 years = Rs. 5, 000 annual depreciation 24

Depreciation Example • Dec 31 – Adjusting entry to record depreciation of equipment JOURNAL Date Accounts 12 -31 Depreciation Expense Debit Credit Rs. 5, 000 Accumulated Depreciation Rs. 5, 000 25

Depreciation – Balance Sheet Plant assets: Equipment Less: Accum. Depr. Rs. 50, 000 (5, 000) Rs. 45, 000 26

Accrued Expenses • Expense incurred before cash is paid • Result in a liability • Common accrued expenses: § Salaries § Interest § Taxes 27

Accrued Salary Expense Example • A company pays its employees a weekly salary each Friday • Salaries for each week total Rs. 10, 000 • December 31, the company’s year-end, falls on a Wednesday 28

Rs. 10, 000 Salaries Rs 6, 000 Monday, December 29 Rs 4, 000 Wednesday, December 31 year end Friday, January 2 pay day Monday through Wednesday = 3 days 3 out of 5 days of salaries expense has been incurred 3/5 x Rs 10, 000 = Rs 6, 000 29

Accrued Salary Expense Example • Dec 31 – Record accrued salary expense JOURNAL Date Accounts 12 -31 Salary expense Debit Credit Rs. 6, 000 Salary payable Rs. 6, 000 30

Accrued Revenues • Companies often earn revenue before cash is received • Results in an accrued revenue § Receivable recorded 31

Accrued Revenue Example • A company performed services for customers during the last week of the year totaling Rs. 5, 000 • The revenue has not yet been recorded because the customers won’t be billed until January 32

Accrued Salary Expense Example • Dec 31 – Record accrued revenue JOURNAL Date Accounts 31/12 Accounts Receivable Debit Credit Rs. 5, 000 Service Revenue Rs. 5, 000 33

Unearned Revenues • Recorded as a liability when company receives payment § Company owes customer product or service • Revenue is not recorded until earned § When company provides product or service • An adjusting entry is made to transfer amount from unearned revenue to revenue 34

Unearned Revenue Example • On November 1, a company receives a customer payment of Rs. 18, 000 for services to be performed during the next three months 35

Unearned Revenue Example • Nov 1 – Record advance payment received by customer JOURNAL Date Accounts 01/11 Cash Debit Credit Rs. 18, 000 Unearned revenue Rs. 18, 000 36

Rs. 18, 000 Rs. 12, 000 November 1, current year Rs. 6, 000 December 31 November 1 to December 31 = 2 months January 31, following year 1 out of 3 months remains unearned 2 out of 3 months of revenue has been earned 2/3 x Rs, 18, 000 = Rs. 12, 000 1/3 x Rs. 18, 000 = Rs. 6, 000 37

Unearned Revenue Example • Dec 31 – Record portion of unearned revenue that has been earned JOURNAL Date Accounts 31/12 Unearned revenue Debit Credit Rs. 12, 000 Service revenue Rs. 12, 000 38

Unearned Revenue Dec 31 Rs. 12, 000 Nov 1 Rs. 18, 000 Dec 31 Rs. 12, 000 Represents amount earned Rs. 6, 000 End-of-year balance Service Revenue Represents amount unearned 39

Summary of Adjusting Entries • Purpose of adjusting entries § Measure income § Update balance sheet • Each adjusting entry affects § One income statement account • Revenue or Expense § One balance sheet account • Asset or liability 40

Adjusted Trial Balance • Trial balance prepared after adjusting entries are made and posted • These amounts are used to prepare the financial statements: § Income Statement – Profit and Loss account § Balance Sheet 41

Income Statement • Reports net income or loss • Revenues minus expenses • Net income flows to Retained Earnings Statement (a. k. a Reserves & Surplus) 42

Statement of Retained Earnings • Shows changes to the Retained Earnings account • Net Income is added to beginning balance • Dividends are subtracted • Ending Retained Earnings flows to the Balance Sheet 43

Balance Sheet • Reports assets, liabilities and equity • Shows that the accounting equation is in balance 44

INCOME STATEMENT NET INCOME RETAINED EARNINGS STATEMENT ENDING RETAINED EARNINGS BALANCE SHEET 45

Closing the Books • Done after financial statements are prepared • Set temporary accounts to zero • Transfers balances to retained earnings account • Journalizes activity in Statement of Retained Earnings 46

Temporary and Permanent Accounts Temporary • Revenues, Expenses and Dividends • Closed • Balances represent a period of time Permanent • Asset, liability and equity accounts • Not closed • Ending balance of one period carries over to following period 47

Closing Entries • Debit each Revenue account for the amount in its credit balance § Retained earnings is credited • Credit each Expense account for the amount in its debit balance § Retained earnings is debited R E D • Credit Dividends for the amount in its debit balance § Retained earnings is debited 48

• Dec 31 – Close Revenues JOURNAL Date Accounts 31/12 Service Revenue Debit Other revenue Retained earnings Credit Rs. 23, 600 Rs. 24, 200 49

Which account would be debited? Total the expenses for the amount • Dec 31 – Close expenses JOURNAL Date Accounts Debit 31 -Dec Retained Earnings Credit Rs. 23, 100 Cost of services sold Rs. 11, 600 Selling, general & admin exp Rs. 6, 900 Depreciation expense Rs. 4, 100 Income tax expense Rs. 500 50

• Dec 31 – Close Dividends JOURNAL Date Accounts 12 -31 Retained earnings Debit Credit Rs. 400 Dividends Rs. 400 51

Retained earnings Expenses Dividends 23, 100 400 Determine net income. Remember revenues minus expenses 1, 900 24, 200 Opening balance Revenues Rs. 2, 600 Closing balance 52

Classifying Assets & Liabilities • Current and long-term classifications are based on liquidity § How quickly item is converted to in cash • Current assets will be converted to cash, sold or used during the next year • Long-term assets include plant assets • Current liabilities must be paid in the next 12 months • Long-term liabilities have due dates more than one year from balance sheet date 53

Classified Balance Sheet • Places assets into meaningful categories • Categories: § § § Current assets Long-term investments Property, plant and equipment Intangible assets Other assets 54

Balance Sheet Formats • Report format § Assets at the top § Followed by liabilities and stockholders’ equity • Account format § Assets on the left § Liabilities and stockholders’ equity on the right 55

Income Statement Formats • Single-step § All revenues and gains grouped together § All expenses and losses grouped together • Multi-step § Includes useful subtotals § Gross profit • Net revenues minus cost of goods sold § Income from operations § Net income 56

Current ratio • Measure company’s ability to pay current liabilities with current assets • Rule of thumb: § Strong current ratio is 1. 50 Current assets Current liabilities 57

Debt Ratio • Proportion of assets that is financed with debt • High debt ratio indicates more risk Total liabilities Total assets 58

S 3 -14 Current ratio: Current assets = Cash + Accounts Receivable + Inventories + Other current assets 900 + 27, 700 + 33, 000 + 4, 800 = Rs. 66, 400 Total Current liabilities = Rs. 53, 600 Current ratio = 66, 400 / 53, 600 Current ratio = 1. 24 59

Debt ratio: Total liabilities = Current liabilities + Long-term liabilities Rs. 53, 600 + Rs. 13, 500 = Rs. 67, 100 Total assets = Current assets + Property & Equipment, net + Other assets Rs. 66, 400 + Rs. 7, 200 + Rs. 24, 300 = Rs. 97, 900 Debt ratio = Rs. 67, 100 / Rs. 97, 900 Debt ratio =. 69 60

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