chapter 2 accounting 203 204

Chapter 2Chapter 2Accounting for Accruals & Accounting for Accruals &

DeferralsDeferralsHi, I’m calling for Solemn &

Sons Funeral Home. Could I interest you in our layaway

plan? Its simple. You pay now and die later.

The ultimate deferral event.

When to Record Revenue?When to Record Revenue?

Assume that an accountant provided tax Assume that an accountant provided tax advice to a client on advice to a client on December 1, 20X3December 1, 20X3, , but agreed to wait until but agreed to wait until January 15, 20X4January 15, 20X4 to be paid.to be paid.

Q:Q: Should the accountant “recognize” Should the accountant “recognize” (record) this revenue, in 20X3 or (record) this revenue, in 20X3 or 20X4?20X4?

A:A: 20X320X3

What is Accrual AccountingWhat is Accrual Accounting

Accrual accounting attempts to record Accrual accounting attempts to record the effects of accounting events in the the effects of accounting events in the period that such events occur, period that such events occur, regardless of when cash is received. regardless of when cash is received. (textbook)(textbook)

Cash information Cash information is important!is important!Cash information is on the Statement of Cash Cash information is on the Statement of Cash

FlowsFlows

Examples of Accrual EventsExamples of Accrual Events

Sales made “on account”Sales made “on account”Purchases made “on account”Purchases made “on account”Wages expense for employeesWages expense for employeesInterest on money borrowed or lentInterest on money borrowed or lent

Covered in detail in Chapter 7Covered in detail in Chapter 7

Income tax expenseIncome tax expense

What is a Deferral?What is a Deferral?

A deferral event occurs when cash is A deferral event occurs when cash is received or paid before revenue is received or paid before revenue is earned or an expense is incurred.earned or an expense is incurred.

Deferral events are a part of the accrual Deferral events are a part of the accrual basis of accountingbasis of accounting

Examples of Deferral EventsExamples of Deferral Events

Prepayments of expensesPrepayments of expensesrent, insurance etc.rent, insurance etc.

Advance receipts of revenuesAdvance receipts of revenuesrent, insurance, etc.rent, insurance, etc.

Purchases of certain assetsPurchases of certain assetsbuildings, equipment, etc.buildings, equipment, etc.Covered in detail in Chapter 9Covered in detail in Chapter 9

Accruals vs. DeferralsAccruals vs. Deferrals

Accrual eventAccrual eventBusiness action followed by Business action followed by CashCash exchange exchange

Deferral eventDeferral eventCashCash exchange followed by Business action exchange followed by Business action

Transaction AnalysisTransaction AnalysisIncluded in the lecture on Chapter 1 were Included in the lecture on Chapter 1 were

six examples of transaction analysis. six examples of transaction analysis. After these events the account After these events the account balances of “Our Company” were:balances of “Our Company” were:CashCash 1,7001,700LandLand 3,5003,500Note payableNote payable 2,0002,000Common stockCommon stock 3,0003,000Retained earningsRetained earnings 200 200

The fifteen events that follow are a The fifteen events that follow are a continuation of the activities for Our continuation of the activities for Our Co. These events occurred in 20X2.Co. These events occurred in 20X2.

Transaction Analysis: ex. 1Transaction Analysis: ex. 1

Provided services to customers for Provided services to customers for $3,000, cash.$3,000, cash.

AssetsAssets == Liab.Liab. ++ C. Stock.C. Stock. ++ Ret. Ret. Earn.Earn.

+ 3,000+ 3,000 n/a n/a n/a n/a + 3,000+ 3,000

Income Statement:Income Statement: net income increased net income increased Statement of Changes in Equity: Statement of Changes in Equity: equity equity

increasedincreased Statement of Cash Flows:Statement of Cash Flows: net cash flow net cash flow

increasedincreased


Provided services to customers for Provided services to customers for $2,000, on account.$2,000, on account.

AssetsAssets = = Liab. Liab. ++ C. StockC. Stock ++ Ret. Ret. Earn.Earn.

+ 2,000 (A/R) + 2,000 (A/R) n/a n/a n/a n/a + 2,000+ 2,000

Income Statement:Income Statement: net income increased net income increased Statement of Changes in Equity: Statement of Changes in Equity: equity increased equity increased Statement of Cash Flows:Statement of Cash Flows: cash flow was not cash flow was not

affectedaffected


Collected $1,200 cash from customers for Collected $1,200 cash from customers for services that we agreed to provide in the services that we agreed to provide in the future.future.

AssetsAssets = = Liab. Liab. ++ C. StockC. Stock ++ Ret. Earn.Ret. Earn.

+ 1,200 (cash) + 1,200 (cash) +1,200 (U/R)+1,200 (U/R) n/a n/a n/a n/a

Income Statement:Income Statement: net income was not affected net income was not affected Statement of Changes in Equity: Statement of Changes in Equity: equity was not affected equity was not affected Statement of Cash Flows:Statement of Cash Flows: net cash flow increased by net cash flow increased by

$1,200$1,200


Incurred cash expenses of $1,000.Incurred cash expenses of $1,000. AssetsAssets = = Liab. Liab. ++ C. StockC. Stock ++ Ret. Ret.

Earn.Earn.

- 1,000 (cash)- 1,000 (cash) n/a n/a n/a n/a - 1,000- 1,000

Income Statement:Income Statement: net income decreased net income decreased Statement of Changes in Equity: Statement of Changes in Equity: equity decreased equity decreased Statement of Cash Flows:Statement of Cash Flows: net cash flow decreased net cash flow decreased


Incurred expenses of $1,700, on account.Incurred expenses of $1,700, on account. AssetsAssets = = Liab. Liab. ++ C. StockC. Stock ++ Ret. Ret.

Earn.Earn.

n/an/a + 1,700 (A/P)+ 1,700 (A/P) n/a n/a - 1,700- 1,700

Income Statement:Income Statement: net income decreased net income decreased Statement of Changes in Equity: Statement of Changes in Equity: equity decreased equity decreased Statement of Cash Flows:Statement of Cash Flows: cash flow was not cash flow was not

affectedaffected


On Nov. 21, paid $1,000, cash, to buy office On Nov. 21, paid $1,000, cash, to buy office supplies, such as paper.supplies, such as paper.


- 1,000 (cash)- 1,000 (cash)

+ 1,000 (O. Supl.)+ 1,000 (O. Supl.) n/a n/a n/a n/a n/a n/a

Income Statement:Income Statement: net income was not affected net income was not affected Statement of Changes in Equity: Statement of Changes in Equity: equity was not equity was not

affectedaffected Statement of Cash Flows:Statement of Cash Flows: net cash flow decreased net cash flow decreased


On Dec. 1, paid $500, cash, to rent office On Dec. 1, paid $500, cash, to rent office space for the next two months.space for the next two months.


- 500 (cash)- 500 (cash)

+ 500 (P/rent)+ 500 (P/rent) n/a n/a n/a n/a n/a n/a




Collected $1,500 cash from account Collected $1,500 cash from account receivable.receivable.


- 1,500 (A/R)- 1,500 (A/R)

+ 1,500 (cash)+ 1,500 (cash) n/a n/a n/a n/a n/a n/a


affectedaffected Statement of Cash Flows:Statement of Cash Flows: net cash flow increased net cash flow increased

Transaction Analysis: ex. 9Transaction Analysis: ex. 9Repaid the $2,000 that was borrowed in 20X1. Repaid the $2,000 that was borrowed in 20X1.

Assume this was an interest free loan.Assume this was an interest free loan. AssetsAssets = = Liab. Liab. ++ C. StockC. Stock ++ Ret. Earn.Ret. Earn.

- 2,000 (cash) - 2,000 (cash) - 2,000 (N/P)- 2,000 (N/P) n/a n/a n/a n/a

Income Statement:Income Statement: net income was not affected net income was not affected Statement of Changes in Equity: Statement of Changes in Equity: equity was not affected equity was not affected Statement of Cash Flows:Statement of Cash Flows: net cash flow decreased by net cash flow decreased by

$2,000$2,000


Paid $1,000, on accounts payable.Paid $1,000, on accounts payable. AssetsAssets = = Liab. Liab. ++ C. StockC. Stock ++ Ret. Ret.

Earn.Earn.

- 1,000 (cash) - 1,000 (cash) - 1,000 (A/P)- 1,000 (A/P) n/a n/a n/a n/a




Accrued wages of $800 for workers. Accrued wages of $800 for workers. (Payday is on Friday, the EOY is on a (Payday is on Friday, the EOY is on a Wednesday.)Wednesday.)


n/an/a + 800 (W/P)+ 800 (W/P) n/a n/a - 800 - 800

Income Statement:Income Statement: net income decreased net income decreased Statement of Changes in Equity: Statement of Changes in Equity: equity decreased equity decreased Statement of Cash Flows:Statement of Cash Flows: net cash flow was not net cash flow was not

affectedaffected


On Dec. 31, recognized that one-fourth of On Dec. 31, recognized that one-fourth of the revenue collected in advance (see the revenue collected in advance (see transaction 3) had been earned.transaction 3) had been earned.


n/an/a - 300 (U/R)- 300 (U/R) n/a n/a + 300 + 300

Income Statement:Income Statement: net income increased net income increased Statement of Changes in Equity: Statement of Changes in Equity: equity increased equity increased Statement of Cash Flows:Statement of Cash Flows: cash flow was not affected cash flow was not affected


On Dec. 31, a physical count of office On Dec. 31, a physical count of office supplies reveled that only $300 were still supplies reveled that only $300 were still on hand. (see transaction 6).on hand. (see transaction 6).


- 700 (O. Supl.)- 700 (O. Supl.) n/a n/a n/a n/a - 700 - 700

Income Statement:Income Statement: net income decreased net income decreased Statement of Changes in Equity: Statement of Changes in Equity: equity decreased equity decreased Statement of Cash Flows:Statement of Cash Flows: cash flow was not affected cash flow was not affected


On Dec. 31, recorded the “expired” rent On Dec. 31, recorded the “expired” rent that had been prepaid on Dec. 1, (see that had been prepaid on Dec. 1, (see transaction 7).transaction 7).


- 250 (P/rent)- 250 (P/rent) n/a n/a n/a n/a - 250 - 250

Income Statement:Income Statement: net income decreased net income decreased Statement of Changes in Equity: Statement of Changes in Equity: equity decreased equity decreased Statement of Cash Flows:Statement of Cash Flows: cash flow was not affected cash flow was not affected


Distributed $100, to owners.Distributed $100, to owners. AssetsAssets = = Liab. Liab. ++ C. StockC. Stock ++ Ret. Earn.Ret. Earn.

- 100 (cash)- 100 (cash) n/a n/a n/a n/a - 100- 100

Income Statement:Income Statement: net income was not affected net income was not affected Statement of Changes in Equity: Statement of Changes in Equity: equity decreased equity decreased Statement of Cash Flows:Statement of Cash Flows: net cash flow decreased net cash flow decreased

Transaction Analysis: Summary Transaction Analysis: Summary AssetsAssets == Liab.Liab. ++ C. StockC. Stock + + Ret. Earn.Ret. Earn. 5,2005,200 == 2,000 2,000 3,000 3,000 200 200+ 3,000 + 3,000 (cash)(cash) + 3,000+ 3,000+ 2,000 + 2,000 (A/R)(A/R) + 2,000+ 2,000+ 1,200 + 1,200 (cash)(cash) + 1,200 + 1,200 (U/R)(U/R) n/a n/a- 1,000 - 1,000 (cash)(cash) - 1,000- 1,000

+ 1,700 + 1,700 (A/P)(A/P) - 1,700- 1,700- 1,000 - 1,000 (cash)(cash) + 1,000 + 1,000 (O/Supl.)(O/Supl.) n/a n/a- 500 - 500 (cash)(cash) + 500 + 500 (P/rent)(P/rent) n/a n/a- 1,500 - 1,500 (A/R)(A/R) + 1,500 + 1,500 (cash)(cash) n/a n/a- 2,000 - 2,000 (cash)(cash) - 2,000 - 2,000 (N/P)(N/P) n/a n/a- 1,000 - 1,000 (cash)(cash) - 1,000 - 1,000 (A/P)(A/P) n/a n/a

n/a n/a + 800 + 800 (W/P)(W/P) - 800- 800 n/an/a - 300 - 300 (U/R)(U/R) + 300+ 300- 700 - 700 (O/Supl.)(O/Supl.) - 700- 700- 250 - 250 (P/rent)(P/rent) - 250- 250- 100 - 100 (cash)(cash) - 100- 100+ 6,350+ 6,350 == + 2,400+ 2,400 + 3,000+ 3,000 + 950+ 950

Bud’s Accounting, LLPBud’s Accounting, LLPIncome Statement Income Statement

For the month ended 20X2For the month ended 20X2 RevenuesRevenues $5,300$5,300

- Expenses- Expenses (4,450 (4,450))

Net incomeNet income $ 850$ 850

Statement of Changes in Statement of Changes in EquityEquity

Beginning common stockBeginning common stock $3,000$3,000

Plus: InvestmentsPlus: Investments 0 0

Ending common stockEnding common stock $3,000$3,000

Beginning retained earningsBeginning retained earnings 200 200

Plus: Net incomePlus: Net income 850 850

Less: dividendsLess: dividends (100) (100)

Ending retained earningsEnding retained earnings 950 950

Total equityTotal equity $3,950$3,950

Balance Sheet Balance Sheet Assets:Assets:

CashCash $1,800$1,800

Accounts receivableAccounts receivable 500 500

Prepaid rentPrepaid rent 250 250

Office supplies inventoryOffice supplies inventory 300 300

LandLand 3,500 3,500

Total assetsTotal assets $6,350$6,350

Liabilities: Liabilities:

Accounts payableAccounts payable $ 700$ 700

Wages payableWages payable 800 800

Unearned revenueUnearned revenue 900 900

Total liabilitiesTotal liabilities 2,400 2,400

Equity:Equity:

Common stockCommon stock 3,000 3,000

Retained earningsRetained earnings 950 950

Total equityTotal equity 3,950 3,950

Total liabilities and equityTotal liabilities and equity $6,350$6,350

Statement of Cash FlowsStatement of Cash FlowsCash flows from operating activities:Cash flows from operating activities:

Cash receipts from revenuesCash receipts from revenues $5,700$5,700

Cash payments for expensesCash payments for expenses (3,500 (3,500))

Net cash flow from oper. activs.Net cash flow from oper. activs. $ 2,200$ 2,200

Cash flows from investing activities:Cash flows from investing activities: 0 0

Cash flows from financing activities:Cash flows from financing activities:

Cash payment for bank loanCash payment for bank loan (2,000) (2,000)

Cash payment for dividendCash payment for dividend ( 100)( 100)

Net increase in cashNet increase in cash 100 100

Plus beginning cash balancePlus beginning cash balance 1,700 1,700

Ending cash balanceEnding cash balance $ 1,800$ 1,800

Usefulness of Financial RatiosUsefulness of Financial Ratios

Financial ratios make it easier to Financial ratios make it easier to compare:compare:

-- Companies of different sizesCompanies of different sizes

-- Data from different years for the Data from different years for the same companysame company

Benchmark financial ratios are often Benchmark financial ratios are often included as contractual restrictions in included as contractual restrictions in loan agreements.loan agreements.

Financial Ratio ExampleFinancial Ratio Example Small-Time Inc.Small-Time Inc. Big-Time Inc.Big-Time Inc.

AssetsAssets $100,000 $100,000 $1,000,000 $1,000,000

LiabilitiesLiabilities 70,000 70,000 400,000 400,000

EquityEquity 30,000 30,000 600,000 600,000

RevenueRevenue $120,000 $120,000 $1,500,000 $1,500,000

ExpensesExpenses 105,000 105,000 1,350,000 1,350,000

Net Income Net Income $ 15,000$ 15,000 $ 150,000 $ 150,000

Which company is the best?Which company is the best?

Ratio Example: AnalysisRatio Example: AnalysisDeciding which is “best” depends on Deciding which is “best” depends on

how “best” is defined.how “best” is defined.If best is defined as “financial position”, If best is defined as “financial position”,

the the debt-to-assets ratiodebt-to-assets ratio can be helpful. can be helpful.If best is defined as current year’s If best is defined as current year’s

performance, the performance, the return-on-assetsreturn-on-assets and and return-on-equity ratiosreturn-on-equity ratios can be helpful. can be helpful.

Compute these ratios for each company.Compute these ratios for each company.

Ratio Example: ComputationsRatio Example: Computations

Small-Time Inc.Small-Time Inc. Big-Time Inc.Big-Time Inc.

Debt-to-Debt-to- 70,000 70,000 400,000 400,000 .

assetsassets 100,000 = 100,000 = 70% 70% 1,000,000 = 1,000,000 = 40%40%

Return-on-Return-on- 15,000 15,000 150,000 150,000 .

assetsassets 100,000 = 100,000 = 15%15% 1,000,000 = 1,000,000 = 15%15%

Return-on-Return-on- 15,00015,000 150,000150,000

equityequity 30,000 = 30,000 = 50%50% 600,000 = 600,000 = 25%25%

Financial Ratios and Financial Ratios and Transaction AnalysisTransaction Analysis

PreviouslyPreviously, transaction analysis was , transaction analysis was defined as:defined as:the determination of how a business event affects the determination of how a business event affects

the financial statementsthe financial statements

To that definition we now To that definition we now addadd::the determination of how a business event affects the determination of how a business event affects

the the financial ratiosfinancial ratios (increase, decrease, or no (increase, decrease, or no effect).effect).

chapter 2 accounting 203 204

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