the mcgraw-hill companies, inc. 2006mcgraw-hill/irwin chapter two accounting for accruals

The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin

Chapter Two

Accounting for Accruals

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.

Event 1: Conner Consultants was started on January 1, 2004, 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

Event 2: During 2004, 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

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

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

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

Event 6: Conner paid $2,000 for advertising costs. The advertisements appeared in 2004.

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

Event 7: Conner signed contracts for $42,000 of consulting services to be performed in 2005.

= 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

Summary of Transactions

Color Code Legend

Green = numbers used in the statement of cash flows

Red = numbers used in the balance sheet

Blue = numbers used in the income statement

Now, let’s prepare the financial statements for

Conner Consulting 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

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, 2004

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, 2004

CONNER CONSULTANTSBalance Sheet

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, 2004

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 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.

= +

(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

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.

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 2005.

Now, let’s move on to events 7 & 8.

Event 7: On March 1, 2005, 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

Event 8: On December 31, 2005, 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 tem to maturity. Interest is due in cash on the maturity date, March 1, 2006.

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$

Adjusting Entries

Update account balances Prior to

preparing financial

statements

= 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 Consulting

at December 31, 2005.

Now, let’s prepare the 2005 financial statements for Conner Consulting using the data presented above.

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, 2005

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, 2005

CONNER CONSULTANTSBalance Sheet

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, 2005

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.

On September 1, 2006, 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

On August 31, 2007, the maturity date of the note, three events are recognized. First, $5,400 of interest expense has accrued since January 1, 2007.

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$

On August 31, 2007, 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$

On August 31, 2007, 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

Vertical Financial Statements

2004 2005Consulting 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

Vertical Financial Statements

2004 2005AssetsCash 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

Vertical Financial Statements

2004 2005Cash 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

The Financial Analyst

How can a financial analyst

know that a company really did

follow GAAP? Certified Public

Accountants

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.

Types of Audit Opinions

Unqualified Adverse

Qualified Disclaimer

Importance of Ethics

Code of Conduct

Sarbanes-Oxley Act

of 2002

Internal Controls

End of Chapter Two