Continued Cash Flow Versus Accrual Accounting

Accrual Accounting Process Accounting An accountant’s functions include ƒ ƒ Classifying and summarizing, made easier by the repetitive nature of business transactions All repetitive transactions of the same nature are recorded and summarized in one account ƒ An account is a storage unit used to classify and summarize money measurements of business activity of a similar nature ƒ Each account has a title T-Account ƒ Has two sides ƒ Debit means Left ƒ Credit means Right ƒ Created for each type of ƒ ƒ ƒ Asset Liability Stockholders’ equity Recording changes in Assets and Liabilities ƒ ƒ Increases in assets are recorded on the left side of the Taccount Decreases are recorded on the right side of the T-account ƒ Reverse for liabilities and stockholders’ equity ƒ Assets = Liabilities + Stockholders’ equity ƒ Assets are on the left side of the Balance Sheet Equation ƒ Liabilities and owners’ equity are on the right side How does a T-account look like? ƒ Like a Capital “T” Summary of T-account Rules Assets (cash, receivables, equipment) Increases Decreases Liabilities (loans payable) Decreases Increases Owners’ equity (contributed capital, retained earnings) Decreases Increases About T-Accounts ƒ ƒ ƒ ƒ What is one major objective of financial statements? ƒ To provide information to “users” regarding the financial performance of a business Which T-account(s) includes the accountant’s estimate of financial performance over a given accounting period? ƒ Retained earnings (includes current period income) Which financial statement provides the details of the financial performance over a given accounting period? ƒ Income statement How do we construct an income statement from the T-account for retained earnings? ƒ Not very easily! But we will try. Components of stockholders’ equity Common Stock Additional Capital Retained Earnings Expenses Dividends Revenue Why record expenses and revenues separately in various T-accounts? Retained Earnings Rent exp. 800 1,000 Salaries 650 1,100 Interest exp. 450 3,000 Salaries 1,000 200 Rent exp. 400 4,500 Dividends 2,000 Interest exp. 350 Sales revenue Interest Income Sales Revenue Interest Income Sales Revenue Sales Revenue (1,000 + 3,000 + 4,500) Interest Income (1,100 + 200) Rent expense (800 + 400) Salaries expense (650 + 1,000) Interest expense (450 + 350) Net Income 8,500 1,300 (1,200) (1,650) (800) 6,150 Why record expenses and revenues separately in various T-accounts? Retained Earnings Rent exp. 800 Salaries 650 Interest exp. 450 Salaries 1,000 Rent exp. 400 Dividends 2,000 Interest exp. 350 1,000 1,100 3,000 200 4,500 Interest Expense 450 350 Dividends 2,000 Sales revenue Interest Income Sales Revenue Interest Income Sales Revenue Sales Revenue 1,000 3,000 4,500 Interest Revenue 1,100 200 Rent Expense 800 400 Salaries Expense 650 1,000 Why record expenses and revenues separately in various T-accounts? Sales Revenue Interest Revenue 1,000 3,000 4,500 8,500 1,100 200 1,300 Interest Expense 450 350 800 Rent Expense 800 400 1,200 Dividends 2,000 Salaries Expense 650 1,000 1,650 Why record expenses and revenues separately in various T-accounts? Sales Revenue 1,000 8,500 3,000 4,500 8,500 Retained Earnings Rent Exp. 1,200 8,500 Sales Revenue Salaries Exp. 1,650 1,300 Interest Revenue Interest Exp. 800 Dividends 2,000 4,150 Interest Revenue 1,100 1,300 200 1,300 Rent Expense Interest Expense 450 350 800 800 800 400 1,200 Dividends 2,000 2,000 Salaries Expense 650 1,000 1,650 1,650 1,200 Why record expenses and revenues separately? A Summary ƒ ƒ ƒ ƒ ƒ ƒ ƒ Revenues, expenses and dividends are temporary Taccounts Information on changes in retained earnings pertaining to a single accounting period is collected in these temporary accounts At the end of the accounting period, balances in these Taccounts are transferred to Retained Earnings The temporary accounts are set to zero at the end of an accounting period in order to start collecting information for the next period Revenues, expenses and dividend accounts are flow accounts Retained earnings is a stock account In fact, all balance sheet accounts are stock accounts Recording expenses: A Summary ƒ Expenses decrease retained earnings. ƒ Decreases in retained earnings are recorded on the left side ƒ Expenses are recorded on the left side Recording Revenues: A Summary ƒ Revenues increase retained earnings. ƒ Increases in retained earnings are recorded on the right side ƒ (Increase in) revenues are recorded on the right side ƒ Decrease in revenues are recorded on the left side Recording Dividends: A Summary ƒ Dividends decrease retained earnings ƒ Therefore, treated similarly to expenses, but dividends is not an expense ƒ Dividends are recorded on the left side Expenses and Revenues: Debits and Credits ƒ Retained earnings (in general) has a credit balance. ƒ Revenues have credit balance (before they are closed out) because ƒ they increase retained earnings ƒ Expenses and dividends have debit balance (before they are closed out) because ƒ they decrease retained earnings ƒ Yes, when cumulative earnings are less than cumulative dividends ƒ Can retained earnings have a debit balance? The Ledger ƒ Accounts are collectively referred to as the ledger ƒ Types of accounts ƒ ƒ Balance Sheet accounts or real accounts or permanent accounts Income statement accounts or nominal accounts or temporary accounts, ƒ i.e., revenue, expenses, and dividends - all these are subdivisions of retained earnings The Recording Process ƒ Journal entries ƒ Adjusting entries ƒ Posting to T-accounts ƒ Trial Balance ƒ Financial statement preparation The Journal ƒ Journal contains a chronological record of the transactions of a business 1. Joe’s Landscaping Service Joe contributes $10,000 in cash ƒ Assets ƒ Cash ƒ +$10,000 = Liabilities + Owners’ Equity Contributed Capital +$10,000 Journal Entry Dr Cash Cr Contributed capital 10,000 10,000 2. The company borrows $3,000 from the bank ƒ Assets ƒ Cash Loans Payable ƒ +$3,000 +$3,000 = Liabilities + Owners’ Equity Journal Entry Dr Cash Cr Loans payable 3,000 3,000 3. Company purchases equipment for $5,000 cash ƒ Assets ƒ Cash ƒ -$5,000 Dr = L + OE Equipment +$5,000 Journal Entry Equipment Cr Cash 5,000 5,000 4. Company performs service for $12,000. The customer pays $8,000 in cash and promises to pay the balance at a later date. ƒ Assets ƒ Cash = L + Owners’ Equity Receivables ƒ +$8,000 Retained Earnings +$4,000 +$12,000 Journal Entry Dr Dr Cash Accounts receivable Cr Retained earnings (Revenue) 8,000 4,000 12,000 5. Company pays $9,000 for expenses (wages, interest, and maintenance) ƒ Assets ƒ Cash ƒ -$9,000 = Liabilities + Owners’ Equity Retained Earnings Journal Entry Dr Retained Earnings (Expenses) Cr Cash -$9,000 9,000 9,000 6. Company pays a dividend of $1,000 ƒ Assets ƒ Cash ƒ -$1,000 Dr = Liabilities + Owners’ Equity Retained Earnings -$1,000 Journal Entry Retained Earnings (Dividends) Cr Cash 1,000 1,000 Posting to T-accounts CASH Dr 10,000 (1) 03,000 (2) 08,000 (4) 06,000 5,000 (3) 9,000 (5) 1,000 (6) Cr Summary ƒ T-accounts ƒ ƒ ƒ ƒ ƒ ƒ ƒ ƒ Debit is Left Credit is Right Increases in Assets – Debits Increases in liabilities – Credits Increases in shareholders’ equity – Credits Expenses are Debits Revenues are Credits Use balances from T-accounts to prepare financial statements at the end of a fiscal period s Adjusting entries: Recall four ways that recognition and cash do not coincide Pay Cash Recognize Expense Time Balance Sheet Date Recognize Expense Pay Cash Time Balance Sheet Date s Adjusting entries: Recall four ways that recognition and cash do not coincide Receive Cash Recognize Revenue Time Balance Sheet Date Recognize Revenue Receive Cash Time Balance Sheet Date Accruals (Accrue Today, Cash Tomorrow) ƒ Accrued Wages ƒ ƒ ƒ ƒ ƒ Employees of Taylor Motor are paid at the end of each week. Payroll per day: $2,000 Weekly payroll: $10,000 (five working days) Taylor’s year ends on December 31. Assume December 31, 2003 falls on a Tuesday ƒ On December 31, 2003 ƒ ƒ Taylor Motor has incurred wage expense for two days But will not pay it in cash until Friday, January 3, 2004. Accruals (Accrue Today, Cash Tomorrow) ƒ Periodic adjustment on December 31 ƒ Assets = Liabilities + Owners’ Equity ƒ Wages Payable Retained Earnings ƒ +4,000 -4,000 ƒ Dr Wage Expense (-RE) 4,000 ƒ Cr Wages Payable (+L) 4,000 ƒ Effect of omitting this journal entry? ƒ ƒ Liabilities are understated by $4,000 Retained earnings & Net income overstated by $4,000 Accruals (Accrue Today, Cash Tomorrow) ƒ What would you see on the balance sheet as of 12/31? ƒ Wages Payable $4,000 under Liabilities ƒ What would you see on the income statement for the year ended 12/31? ƒ ƒ Wage Expense of $520,000 52 Weeks x $10,000 per week ƒ ƒ ƒ Wage expense would have been $4,000 less. Expense would have been understated Net income overstated ƒ Without the adjusting entry Accruals (Accrue Today, Cash Tomorrow) ƒ $10,000 paid on Jan. 3 of 2004. ƒ Assets = Liabilities + Owners’ Equity ƒ Cash Wages Payable Retained Earnings ƒ -10,000 -4,000 -6,000 ƒ Dr Wage Expense (-RE) 6,000 ƒ Dr Wages Payable (-L) 4,000 ƒ Cr Cash (-A) 10,000 ƒ What would be the balance in the T-account for Wage Expense on January 3rd? ƒ $6,000 Accruals (Accrue Today, Cash Tomorrow) ƒ Consider the $10,000 paid to the employees. ƒ Where and How would it show up in the financial statements? Period 1 Cash Flow Statement Operating cash flow Income Statement Wage expense (-RE) Period 2 -10,000 -4,000 -6,000 Cost Expirations (Cash Yesterday, Accrual Today) ƒ Supplies Inventory ƒ ƒ During 1994 Deere and Company purchases (for cash) supplies in the form of spare parts to support the manufacture of farm machinery at a total cost of $700. The company began the year with $500 in the supplies account. ƒ Assets ƒ Cash ƒ -700 = Liabilities Supplies +700 + OE Cost Expirations (Cash Yesterday, Accrual Today) ƒ On December 31, a count reveals that supplies in the ƒ amount of $300 remain on hand. Supplies Used = Beg. Inv. + Purchases - Ending Inventory ƒ = $500 + $700 - $300 ƒ = $900 ƒ Assets = L + ƒ Supplies ƒ -900 ƒ Dr Supplies Expense (-RE) ƒ Cr Supplies Inventory (-A) Owners’ Equity Retained Earnings -900 900 900 Cost Expirations (Cash Yesterday, Accrual Today) Supplies Account Beg bal Purchases Ending Inv ƒ ƒ 500 900 Supplies expense 700 300 Supplies expense of $900 is the adjusting entry and the corresponding debit is to Retained Earnings (i.e., expense on the income statement that affects retained earnings). The Ending Inventory of $300 appears on the balance sheet (and it serves as the ending inventory for the current fiscal period and beginning inventory for the following fiscal period). Cost Expirations (Cash Yesterday, Accrual Today) ƒ What shows up in the cash flow statement? ƒ ƒ The cash paid during the year for purchase of supplies Operating outflow = $700 ƒ ƒ The cost of supplies consumed during the year Supplies expense = $900 ƒ Ending balance in Supplies of $300 ƒ What shows up in the income statement? ƒ What shows up in the balance sheet? Cost Expirations (Cash Yesterday, Accrual Today) ƒ Pre-received revenues ƒ ƒ ƒ ƒ Unearned revenue Fees received in advance Customer advances Subscription received in advance, etc. ƒ Time Warner receives $5,000 during 1994 for magazine subscriptions to be fulfilled during 1994 and 1995. Assume that as of the end of 1994 Time had fulfilled 60% of the subscriptions. Cost Expirations (Cash Yesterday, Accrual Today) ƒ $5,000 received during 1994 ƒ Assets = Liabilities + OE ƒ Cash Unearned Revenue ƒ +5,000 +5,000 ƒ Dr Cash (+A) 5,000 ƒ Cr Unearned Revenue (+L) 5,000 ƒ What happens to this liability at the end of 1994? ƒ Decreases by 60% because Time Warner delivers magazines in 1994. Cost Expirations (Cash Yesterday, Accrual Today) ƒ Assets = Liabilities + Owners’ Equity ƒ Unearned Revenue Retained Earnings ƒ -3,000 +3,000 ƒ Dr Unearned Revenue (-L) 3,000 ƒ Cr Subscription Revenue (+RE) 3,000 ƒ Effect of omitting this entry? ƒ ƒ Liabilities are overstated by $3,000 Retained earnings (income) understated by $3,000 Cost Expirations (Cash Yesterday, Accrual Today) ƒ Effect on financial statements? ƒ 1994 1995 ƒ Operating cash inflow (+) +5,000 ƒ Subscription revenue (+RE) +3,000 +2,000 ƒ What do you see in the balance sheet as of 12/31/94? ƒ ƒ Liabilities: Unearned Revenue = $2,000 Represents the obligation for unfulfilled journal subscriptions. Summary ƒ Accrual accounting can be confusing! ƒ Understand the logic behind it and it will be clear.