© the mcgraw-hill companies, inc., 2008 mcgraw-hill/irwin chapter two accounting for accruals
TRANSCRIPT
© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Chapter Two
Accounting for Accruals
2-2
Accrual Accounting
Virtually all of the major companies operating in the United States use
accrual accounting.
Let’s demonstrate
accrual accounting by
describing seven events
that relate to a company named
Conner Consultants.
2-3
LO 1
Record basic accrual events in
a horizontal financial
statements model.
2-4
Event 1: Conner Consultants was started on January 1, 2008, when it acquired $5,000 cash by issuing common stock.
1. Increase assets (cash).
2. Increase stockholders’ equity (common stock).
Asset Source
Transaction
= Liab. +
Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
5,000 + n/a = n/a + 5,000 + n/a n/a - n/a = n/a 5,000 FA
Assets Stockholders' Equity
Cash Flow
2-5
Event 2: During 2008, Conner Consultants provided $84,000 of consulting services to its clients but no cash has been collected.
1. Increase assets (accounts receivable).
2. Increase stockholders’ equity (retained earnings).
Asset Source
Transaction
= Liab. +
Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses = Net Income
n/a + 84,000 = n/a + n/a + 84,000 84,000 - n/a = 84,000 n/a
Assets Stockholders' Equity
Cash Flow
New Event
2-6
Event 3: Conner collected $60,000 cash from customers in partial settlement of its accounts receivable.
1. Increase assets (cash).
2. Decrease assets (accounts receivable).
Asset Exchange
Transaction
= Liab. +
Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
60,000 + (60,000) = n/a + n/a + n/a n/a - n/a = n/a 60,000 OA
Assets Stockholders' Equity
Cash Flow
New Event
2-7
Event 4: The instructor earned a salary of $16,000. No cash has yet been paid to the employee.
1. Increase liabilities (salaries payable).
2. Decrease stockholders’ equity (retained earnings).
Claims Exchange
Transaction
= Liab. +
Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
n/a + n/a = 16,000 + n/a + (16,000) n/a - 16,000 = (16,000) n/a
Assets Stockholders' Equity
Cash Flow
Salaries Expense
New Event
2-8
Event 5: Conner paid $10,000 to the instructor in partial settlement of salaries payable.
1. Decrease assets (cash).
2. Decrease liabilities (salaries payable).
Asset Use Transaction
= Liab. +
Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
(10,000) + n/a = (10,000) + n/a + n/a n/a - n/a = n/a (10,000) OA
Assets Stockholders' Equity
Cash Flow
New Event
2-9
Event 6: Conner paid $2,000 for advertising costs. The advertisements appeared in 2008.
1. Decrease assets (cash).
2. Decrease stockholders’ equity (retained earnings).
Asset Use Transaction
= Liab. +
Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
(2,000) + n/a = n/a + n/a + (2,000) n/a - 2,000 = (2,000) (2,000) OA
Assets Stockholders' Equity
Cash Flow
Advertising Expense
2-10
Event 7: Conner signed contracts for $42,000 of Consultants services to be performed in 2009.
= Liab. +
Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
n/a + n/a = n/a + n/a + n/a n/a - n/a = n/a n/a
Assets Stockholders' Equity
Cash Flow
2-11
LO 2
Organize general ledger accounts
under an accounting equation.
2-12
Summary of Transactions
Now, let’s prepare the financial statements for Conner
Consultants using the data presented above.
= Liab. +
Event No. Cash + Accounts
Receivable = Salaries Payable +
Common Stock +
Retained Earnings
Other Account
Titles Beg. Bal. -$ -$ -$ -$ -$
1 5,000 5,000 2 84,000 84,000 Revenue3 60,000 (60,000) 4 16,000 (16,000) Expense5 (10,000) (10,000) 6 (2,000) (2,000) Expense
End. Bal. 53,000$ + 24,000$ = 6,000$ + 5,000$ + 66,000$
Assets Stockholders' Equity
2-13
LO 3
Prepare financial statements based
on accrual accounting.
2-14
Preparing Financial Statements
Consulting Revenue 84,000$ Salary Expense (16,000) Advertising Expense (2,000) Net Income 66,000$
Beginning Common Stock -$ Plus: Common Stock Issued 5,000 Ending Common Stock 5,000$ Beginning Retained Earnings -$ Plus: Net Income 66,000 Less: Dividends - Ending Retained Earnings 66,000 Total Stockholders' Equity 71,000$
CONNER CONSULTANTSIncome Statement
For the Year Ended December 31, 2008
CONNER CONSULTANTSStatement of Changes in Stockholders' Equity
For the Year Ended December 31, 2008
Earned--not all received
Incurred not paid
2-15
Preparing Financial Statements
AssetsCash 53,000$ Accounts Receivable 24,000 Total Assets 77,000$
LiabilitiesSalaries Payable 6,000$
Stockholders' EquityCommn Stock 5,000$ Retained Earnings 66,000 Total Stockholders' Equity 71,000 Total Liabilities and Stockholders' Equity 77,000$
As of December 31, 2008
CONNER CONSULTANTSBalance Sheet
2-16
Preparing Financial Statements
Cash Flows from Operating ActivitiesCash Receipts from Customers 60,000$ Cash Payments for Salary Expense (10,000) Cash Payments for Advertising Expenses (2,000)
Net Cash Flow from Operating Activities 48,000$ Cash Flows for Investing Activities - Cash Flows from Financing ActivitiesCash Receipts from Issuing Common Stock 5,000 Net Increase in Cash 53,000 Plus Beginning Cash Balance - Ending Cash Balance 53,000$
CONNER CONSULTANTSStatement of Cash Flows
For the Year Ended December 31, 2008
2-17
LO 4
Describe the matching concept,
the accounting cycle and the
closing process.
2-18
The Closing Process
Transfers net income (or loss) and dividends to Retained Earnings.
Establishes zero balances in all
revenue, expense, and dividend accounts.
Temporary Accounts
2-19
Temporary accounts track financial
results for a limited period of time.
Temporary accounts track financial
results for a limited period of time.
Temporary and Permanent Accounts
Revenues
Exp
ense
s
Divid
end
s
TemporaryAccounts
Permanent Accounts
Assets
Lia
bili
ties E
qu
ity
Permanent accounts track financial
results from year to year.
Permanent accounts track financial
results from year to year.
2-20
= +
(1) 5,000 (4) 16,000 (1) 5,000
(3) 60,000 (5) (10,000) (5) (10,000) 6,000
(6) (2,000) Cl. 1 84,000 Bal. 53,000 Cl. 2 (16,000)
Cl. 3 (2,000) Bal. 66,000
(2) 84,000 (3) (60,000) Bal. 24,000 (2) 84,000
Cl. 1 (84,000) Bal. -
(4) 16,000 Cl. 2 (16,000) Bal. -
(6) 2,000 Cl. 3 (2,000) Bal. -
CashAssets
Accounts Receivable
LiabilitiesSalaries Payable
Advertising Expense
Stockholders' EquityCommon Stock
Retained Earnings
Consulting Revenue
Salary Expense
General Ledger Accounts Here are the
general ledger
accounts for Conner
Consultants after closing
the temporary accounts.
Closing Entries:
Cl. 1: Transfers balance in revenue to retained earnings
Cl. 2 & 3: Transfer balances in expenses to retained earnings
2-21
Matching Concept
The objective of accrual accounting is to improve matching of revenues with expenses.
Cash basis accounting can distort the measurement of
net income because it sometimes fails to properly
match revenues with expenses.
The problem is that cash is not always received or paid
in the period when the revenue is earned or when
the expense is incurred.
2-22
LO 5 Record business events involving interest-bearing receivables and payables in a
horizontal financial
statements model.
2-23
Since you are familiar with these types of events, let’s look at the summary of the general ledger
accounts for Conner Consultants.
Second Accounting Cycle
= Liab. +
Event No. Cash + Accounts
Receivable + Interest
Receivable + Certificate of Deposit =
Salaries Payable +
Common Stock +
Retained Earnings
Other Account
Titles Beg. Bal. 53,000 24,000 - - 6,000 5,000 66,000
1 25,000 25,000 2 96,000 96,000 Cons. Rev. 3 102,000 (102,000)4 22,000 (22,000) Sal. Exp. 5 (20,000) (20,000)6 (10,000) (10,000) Dividends 7 8
End. Bal.
Assets Stockholders' Equity
Event 1 Conner Consultants acquired $25,000 cash by issuing common stock.Event 2 During the period, Conner recognized $96,000 of revenue on account.
Event 3 Conner collected $102,000 of cash from accounts receivable.Event 4 Conner accrued $22,000 of salary expense.Event 5 Conner paid $20,000 cash toward the settlement of salaries payable.Event 6 Conner paid a $10,000 cash dividend to stockholders.
Assume the following events apply to Conner Consultants during 2009.
Now, let’s move on to events 7 & 8.
2-24
Event 7: On March 1, 2009, Conner invested $60,000 in a certificate of deposit (CD).
1. Decrease assets (cash).
2. Increase assets (certificate of deposit).
Asset Exchange
Transaction
= Liab. +
Cash + Accounts
Rec. + Interest
Rec. + Certificate of Deposit =
Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
(60,000) + n/a + n/a + 60,000 = n/a + n/a + n/a n/a - n/a = n/a (60,000) IA
Assets Stockholders' Equity
Cash Flow
Investing Activity
2-25
Event 8: On December 31, 2009, Conner adjusted the books to recognize interest revenue earned to date on the CD. The CD had a 6 percent annual rate of interest and a one-year term to maturity. Interest is due in cash on the maturity date, March 1, 2010.
1. Increase assets (interest receivable).
2. Increase stockholders’ equity (retained earnings).
Asset Source
Transaction
= Liab. +
Cash + Accounts
Rec. + Interest
Rec. + Certificate of Deposit =
Salaries Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
n/a + n/a + 3,000 + n/a = n/a + n/a + 3,000 3,000 - n/a = 3,000 n/a Cash Flow
Assets Stockholders' Equity
Principal
Annual interest
rate Time
outstanding = Interest revenue
60,000$ 0.06 10/12 = 3,000$
Interest Revenue
2-26
Adjusting Entries
Update account balances Prior to
preparing financial
statements
2-27
= Liab. +
Event No. Cash + Accounts
Receivable + Interest
Receivable + Certificate of Deposit =
Salaries Payable +
Common Stock +
Retained Earnings
Other Account
Titles Beg. Bal. 53,000 24,000 - - 6,000 5,000 66,000
1 25,000 25,000 2 96,000 96,000 Cons. Rev. 3 102,000 (102,000)4 22,000 (22,000) Sal. Exp. 5 (20,000) (20,000)6 (10,000) (10,000) Dividends 7 (60,000) 60,000 8 3,000 3,000 Int. Rev.
End. Bal. 90,000 + 18,000 + 3,000 + 60,000 = 8,000 + 30,000 + 133,000
Assets Stockholders' Equity
Summary of General Ledger Accounts
Here is a summary of the general ledger accounts for Conner Consultants at
December 31, 2009.
Now, let’s prepare the 2009 financial statements for Conner Consultants using the data presented above.
2-28
Preparing Financial Statements
Consulting Revenue 96,000$ Interest Revenue 3,000 Total Revenue 99,000$ Salary Expense (22,000) Net Income 77,000$
Beginning Common Stock 5,000$ Plus: Common Stock Issued 25,000 Ending Common Stock 30,000$ Beginning Retained Earnings 66,000$ Plus: Net Income 77,000 Less: Dividends (10,000) Ending Retained Earnings 133,000 Total Stockholders' Equity 163,000$
CONNER CONSULTANTSIncome Statement
For the Year Ended December 31, 2009
CONNER CONSULTANTSStatement of Changes in Stockholders' Equity
For the Year Ended December 31, 2009
2-29
Preparing Financial Statements
AssetsCash 90,000$ Accounts Receivable 18,000 Interest Receivable 3,000 Certificate of Deposit 60,000 Total Assets 171,000$
LiabilitiesSalaries Payable 8,000$
Stockholders' EquityCommn Stock 30,000$ Retained Earnings 133,000 Total Stockholders' Equity 163,000 Total Liabilities and Stockholders' Equity 171,000$
As of December 31, 2009
CONNER CONSULTANTSBalance Sheet
equal
2-30
Preparing Financial Statements
Cash Flows from Operating ActivitiesCash Receipts from Customers 102,000$ Cash Payments for Salary Expense (20,000)
Net Cash Flow from Operating Activities 82,000$ Cash Flows for Investing ActivitiesCash Payments to Purchase CD (60,000) Cash Flows from Financing ActivitiesCash Receipts from Issuing Common Stock 25,000 Cash Payment for Dividends (10,000) Net Cash Flow from Financing Activities 15,000 Net Increase in Cash 37,000 Plus Beginning Cash Balance 53,000 Ending Cash Balance 90,000$
CONNER CONSULTANTSStatement of Cash Flows
For the Year Ended December 31, 2009
2-31
Steps in an Accounting Cycle
Record Transaction
s
Adjust Accounts
Prepare Statements
Close Nominal Accounts
Now, let’s look at some more
transactions for Conner
Consultants.
1.
2.
3.
4.
2-32
On September 1, 2010, Conner borrowed $90,000 cash from First City Bank by issuing a 1 year note at 9% interest.
1. Increase assets (cash).
2. Increase liabilities (notes payable).
Asset Source
Transaction
= +
Cash + = Notes
Payable + Interest Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
90,000 + = 90,000 n/a + n/a + n/a n/a - n/a = n/a 90,000 FA
Assets Stockholders' EquityLiabilities
Cash Flow
Financing Activity
4/12 for interest would be calculated in 2010
2-33
On August 31, 2011, the maturity date of the note, three events are recognized. First, $5,400 of interest expense has accrued since January 1, 2011.
1. Increase liabilities (interest payable).
2. Decrease stockholders’ equity (retained earnings).
Claims Exchange
Transaction
= +
Cash + = Notes
Payable + Interest Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
n/a + = n/a 5,400 + n/a + (5,400) n/a - 5,400 = (5,400) n/a
Assets Stockholders' EquityLiabilities
Cash Flow
Principal
Annual interest
rate Time
outstanding = Interest expense
90,000$ 0.09 8/12 = 5,400$ Interest Expense
2-34
On August 31, 2011, the maturity date of the note, three events are recognized. Second, cash is paid for $8,100, the total amount of interest due on the note.
1. Decrease assets (cash).
2. Decrease liabilities (interest payable).
Asset Use Transaction
= +
Cash + = Notes
Payable + Interest Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
(8,100) + = n/a (8,100) + n/a + n/a n/a - n/a = n/a (8,100) OA Cash Flow
Assets Stockholders' EquityLiabilities
Principal
Annual interest
rate Time
outstanding = Interest payable
90,000$ 0.09 12/12 = 8,100$
2-35
On August 31, 2011, the maturity date of the note, three events are recognized. Third, Conner must recognize the repayment of the $90,000 principal of the note.
1. Decrease assets (cash).
2. Decrease liabilities (notes payable).
Asset Use Transaction
= +
Cash + = Notes
Payable + Interest Payable +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
(90,000) + = (90,000) n/a + n/a + n/a n/a - n/a = n/a (90,000) FA
Assets Stockholders' EquityLiabilities
Cash Flow
2-36
LO 6 & 7Prepare a vertical
financial statements
model.
Explain how business events affect financial
statements over multiple
accounting cycles
2-37
Vertical Financial Statements
2008 2009Consulting Revenue 84,000$ 96,000$ Interst Revenue - 3,000 Salary Expense (16,000) (22,000) Advertising Expense (2,000) - Net Income 66,000$ 77,000$
Beginning Common Stock -$ 5,000$ Plus: Common Stock Issued 5,000 25,000 Ending Common Stock 5,000 30,000 Beginning Retained Earnings - 66,000 Plus: Net Income 66,000 77,000 Less: Dividends - (10,000) Ending Retained Earnings 66,000 133,000 Total Stockholders' Equity 71,000$ 163,000$
CONNER CONSULTANTSIncome Statements
For the Years Ended December 31
Changes in Stockholders’ Equity Statement
2-38
Vertical Financial Statements
2008 2009AssetsCash 53,000$ 90,000$ Accounts Receivable 24,000 18,000 Interest Receivable - 3,000 Certificate of Deposit - 60,000 Total Assets 77,000$ 171,000$
LiabilitiesSalaries Payable 6,000$ 8,000$
Stockholders' EquityCommn Stock 5,000$ 30,000 Retained Earnings 66,000 133,000 Total Stockholders' Equity 71,000 163,000 Total Liabilities and Stockholders' Equity 77,000$ 171,000$
Balance SheetsAs of December 31
CONNER CONSULTANTS
2-39
Vertical Financial Statements
2008 2009Cash Flows from Operating ActivitiesCash Receipts from Customers 60,000$ 102,000 Cash Payments for Salary Expense (10,000) (20,000) Cash Payments for Advertising Expenses (2,000) -
Net Cash Flow from Operating Activities 48,000 82,000$ Cash Flows for Investing Activities - Cash Payment to Purchase CD - (60,000) Cash Flows from Financing ActivitiesCash Receipts from Issuing Common Stock 5,000 25,000 Cash Payments for Dividends - (10,000) Net Cash Flow from Financing Activities 5,000 15,000 Net Increase in Cash 53,000 37,000 Plus Beginning Cash Balance - 53,000 Ending Cash Balance 53,000$ 90,000$
CONNER CONSULTANTSStatement of Cash Flows
For the Years Ended December 31
2-40
LO 8
Discuss the primary
components of corporate
governance.
2-41
Corporate Governance
Corporate governance is the set of relationships between the board of directors, management, shareholders, auditors, and other stakeholders that determines how a company is operated.
2-42
Importance of Ethics
• The accountant’s role requires trust and credibility.
• Accounting information is worthless if the accountant is not trustworthy.
• Therefore, the accounting profession requires high ethical standards.
2-43
AICPA Code of Professional Ethics
Includes articles requiring CPAs to• Exercise sensitive professional and moral
judgments.• Act in a way to serve the public interest.• Perform with the highest sense of integrity.• Be objective and independent, in fact and
appearance.• Exercise due care.
Sarbanes-Oxley Act
• Prompted by the audit failures of Enron, WorldCom, and others
• Key provisions:– Created the Public Company Accounting
Oversight Board (PCAOB)– Requires management to certify financial
statements– Imposes harsh penalties on management for
violations
2-44
2-45
The Fraud Triangle
RationalizationPressure
Opportunity
Key to protecting yourself and your company: personal integrity.
2-46
LO 9
Classify accounting events
into one of four categories.
2-47
Recap: Types of Transactions
The described transactions can be classified into one of four
categories:Asset
use
Increase assets,
increase claims
on assets
Increase one asset, decrease another
asset
Decrease assets,
decrease claims on
assets
Asset source
Asset exchange
Claimsexchange
Increase one claims account, decrease another.
2-48
LO 10
Appendix:Describe the
auditor’s role in financial
reporting.
2-49
The Financial Analyst
How can a financial analyst
know that a company really did
follow GAAP? Certified Public
Accountants
2-50
Materiality and Financial Audits
Auditors do not guarantee that financial statements are absolutely
correct—only that they are materially correct.
Material ItemAn error, or other
reporting problem, that would influence
the decision of an average prudent
investor.
2-51
Types of Audit Opinions
Unqualified Adverse
Qualified Disclaimer
2-52
End of Chapter Two