©the mcgraw-hill companies, inc. 2006mcgraw-hill/irwin chapter three accounting for deferrals

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

Chapter Three

Accounting for Deferrals

Deferral AccountingA deferral involves

recognizing a revenue or expense at

some time after cash has been

collected or paid.

Let’s use seven

transactions for Marketing

Magic, Inc. (MMI) to illustrate

accounting for deferrals.

Event 1: MMI acquired $1,000 cash by issuing common stock.

1. Increase assets (cash).

2. Increase stockholders’ equity (common stock).

Asset Source

Transaction

= Liab. +

Cash + Computer

Equip. - Accum.

Depr. =

Unearned Revenue +

Common Stock +

Retained Earnings Revenue - Expenses =

Net Income

1,000 + n/a - n/a = n/a + 1,000 + n/a n/a - n/a = n/a 1,000 FA

Assets Stockholders' Equity

Cash Flow

By now, you should be pretty familiar with this type of transaction.

Event 2: On January 1, 2004, MMI received $72,000 cash in advance from Westberry for services to be performed from March 1, 2004, through February 28, 2005.


2. Increase liabilities (unearned revenue).

Asset Source

Transaction

= Liab. +

Cash + Computer

Equip. - Accum.

Depr. =

Unearned Revenue +

Common Stock +


Net Income

72,000 + n/a - n/a = 72,000 + n/a + n/a n/a - n/a = n/a 72,000 OA


Cash Flow

Event 3: MMI signed contracts to provide $58,000 of marketing services in 2005.

= Liab. +

Cash + Computer

Equip. - Accum.

Depr. =

Unearned Revenue +

Common Stock +


Net Income

n/a + n/a - n/a = n/a + n/a + n/a n/a - n/a = n/a n/a


Cash Flow

Event 4: MMI paid $12,000 cash to purchase computer equipment.

1. Increase assets (computer equipment).

2. Decrease assets (cash).

Asset Exchange

Transaction

= Liab. +

Cash + Computer

Equip. - Accum.

Depr. =

Unearned Revenue +

Common Stock +


Net Income

(12,000) + 12,000 - n/a = n/a + n/a + n/a n/a - n/a = n/a (12,000) IA


Cash Flow

Event 5: MMI adjusted its accounts to recognize the revenue earned in 2004.

1. Decrease liabilities (unearned revenue).

2. Increase stockholders’ equity (retained earnings).

Claims Exchange

Transaction

= Liab. +

Cash + Computer

Equip. - Accum.

Depr. =

Unearned Revenue +

Common Stock +


Net Income

n/a + n/a - n/a = (60,000) + n/a + 60,000 60,000 - n/a = 60,000 n/a


Cash Flow

$ 72,000 12 months 6,000$ 10 months

$6,000 per month $60,000 revenue in 2004

Event 6: MMI adjusted its accounts to recognize the expense of using the computer equipment during 2004. The equipment was purchased on January 1, 2004 at a cost of $12,000. It had an expected life of four years and a $2,000 salvage value.

1. Decrease assets (accumulated depreciation).

2. Decrease stockholders’ equity (retained earnings).

Asset Use Transaction

= Liab. +

Cash + Computer

Equip. - Accum.

Depr. =

Unearned Revenue +

Common Stock +


Net Income

n/a + n/a - 2,500 = n/a + n/a + (2,500) n/a - 2,500 = (2,500) n/a Cash Flow


(Cost Salvage Value) = Depreciation Expense($12,000 $2,000) = $2,500

Straight-Line Depreciation Useful Life

4 years

Accumulated Depreciation and Book Value

Book Value = Cost - Accumulated Depreciation

Accumulated

Depreciation

Contra Asset

Account

Event 7: MMI paid a $50,000 cash dividend to the stockholders.

1. Decrease assets (cash).



= Liab. +

Cash + Computer

Equip. - Accum.

Depr. =

Unearned Revenue +

Common Stock +


Net Income

(50,000) + n/a - n/a = n/a + n/a + (50,000) n/a - n/a = n/a (50,000) FA Cash Flow


Ledger Accounts

Now, let’s prepare the financial statements for MMI using the data

presented above.

= +

(1) 1,000 (2) 72,000 (1) 1,000 (2) 72,000 (5) (60,000) (4) (12,000) Bal. 12,000

(7) (50,000) Bal. - Bal. 11,000

(5) 60,000 (4) 12,000

(6) (2,500) (6) (2,500)

(7) (50,000)

Assets Liabilities Stockholders' EquityCash Unearned Revenue Common Stock

Retained Earnings

Computer Equipment

Depreciation Exp.Accumulated Depr.

Service Revenue

Dividends

Preparing Financial Statements

Service Revenue 60,000$ Depreciation Expense (2,500) Net Income 57,500$

Beginning Common Stock -$ Plus: Common Stock Issued 1,000 Ending Common Stock 1,000$ Beginning Retained Earnings -$ Plus: Net Income 57,500 Less: Dividends (50,000) Ending Retained Earnings 7,500 Total Stockholders' Equity 8,500$

MARKETING MAGIC, INC.Income Statement

For the Year Ended December 31, 2004


AssetsCash 11,000$ Computer Equipment 12,000 Less: Accumulated Depreciation (2,500) 9,500 Total Assets 20,500$

LiabilitiesUnearned Revenue 12,000$

Stockholders' EquityCommn Stock 1,000$ Retained Earnings 7,500 Total Stockholders' Equity 8,500 Total Liabilities and Stockholders' Equity 20,500$

As of December 31, 2004

MARKETING MAGIC, INC.Balance Sheet


Cash Flows from Operating ActivitiesCash Receipts from Customers 72,000$ Cash Flows for Investing ActivitiesCash Payment for Computer Equipment (12,000) Cash Flows from Financing ActivitiesCash Receipts from Issuing Common Stock 1,000$ Cash Payment for Dividends (50,000) Net Cash Flows from Financing Activities (49,000) Net Increase in Cash 11,000 Plus Beginning Cash Balance - Ending Cash Balance 11,000$

MARKETING MAGIC, INC.Statement of Cash Flows


The Matching ConceptThree Common Matching Practices

1. Costs may be matched directly with the revenues they generate.

2. The costs of items with short or undeterminable useful lives are matched with the period in which they are incurred.

3. The costs of long-term assets with identifiable useful lives are systematically allocated over the assets’ useful lives.

Prepaid Expenses

SuppliesPrepaid Insuranc

e

Prepaid Rent

CostExpense

Expense

Asset

Second Accounting Cycle Event 1 Acquired additional $5,000 cash from issuing common stock. Event 2 Paid $400 cash for supplies Event 3 Paid $1,200 cash for an insurance policy that provided coverage for one

year beginning February 1, 2005.

Event 4 Recognized revenue for $108,000 of services provided on account. Event 5 Collected $89,000 of the receivables due from customers. Event 6 Recognized $32,000 of operating expenses purchased on account. These

are expenses in addition to supplies and insurance and are classified as other operating expenses.

Event 7 Paid suppliers $28,000 of the amount owed on accounts payable. Event 8 Paid a $70,000 cash dividend to stockholders. Event 9 Purchased land for $3,000.

Event 10 Recognized the remainder of the unearned revenue. All services had been provided by February 28, 2005, as specified in the orpginal contract with Westberry.

Event 11 Recognized 2005 depreciation expense. Event 12 Recognized supplies expense; $150 of supplies were on hand at the

close of business on December 31, 2005. Event 13 Recognized insurance expense for 11 months.

Adjusting Entries

MMI experienced the following transactions during 2005:

Let’s focus on the

last two

events.

Event 12: Recognized supplies expense; $150 of supplies was on hand at the close of business on December 31, 2005.

1. Decrease assets (supplies).



Beginning Balance

+ Purchases =Asset

Available for Use

-Ending

Balance=

Asset Used

-$ + 400$ = 400$ - 150$ = 250$

Event 13: Recognized insurance expense for 11 months.

1. Decrease assets (prepaid insurance).



$ 1,200 12 months 100$ 11 months

$100 per month $1,100 expense in 2004

Now, let’s look at the summary of the ledger accounts at the end of 2005.

= +

Bal. 11,000 Bal. - Bal. - Bal. 1,000 (1) 5,000 (3) 1,200 (6) 32,000 (1) 5,000 (2) (400) (13) (1,100) (7) (28,000) Bal. 6,000

(3) (1,200) Bal. 100 Bal. 4,000

(5) 89,000 (7) (28,000) Bal. 7,500 (8) (70,000) (4) 12,000 Bal. 12,000 (9) (3,000) (10) (12,000) Bal. 2,400 Bal. - (4) 108,000

Bal. (2,500) (10) 12,000 (11) (2,500) Bal. 120,000

Bal. - Bal. (5,000)

(4) 108,000 (5) (89,000) (6) (32,000) Bal. 19,000 Bal. -

(9) 3,000 Bal. 3,000 (11) (2,500)

Bal. - (2) 400 (12) (250) (12) (250) Bal. 150

(13) (1,100)

(8) (70,000)

Supplies Expense

Insurance Exp.

Stockholders' Equity

Computer Equipment

Accumulated Depr.

Land

Unearned Revenue

Service Revenue

Dividends

Supplies

Prepaid Insurance

Retained Earnings

Accounts Receivable

Other Operating Exp.

Depreciation Exp.

LiabilitiesCash Accounts Payable Common Stock

Assets

Now, let’s prepare the 2005 financial statements.


Service Revenue 120,000$ Operating Expenses 32,000$ Depreciation Expense 2,500 Supplies Expense 250 Insurance Expense 1,100 Total Expenses (35,850) Net Income 84,150$

Beginning Common Stock 1,000$ Plus: Common Stock Issued 5,000 Ending Common Stock 6,000$ Beginning Retained Earnings 7,500$ Plus: Net Income 84,150 Less: Dividends (70,000) Ending Retained Earnings 21,650 Total Stockholders' Equity 27,650$




AssetsCash 2,400$ Accounts Receivable 19,000 Supplies 150 Prepaid Insurance 100 Computer Equipment 12,000$ Less: Accumulated Depreciation (5,000) 7,000 Land 3,000 Total Assets 31,650$

LiabilitiesAccounts Payable 4,000$

Stockholders' EquityCommn Stock 6,000$ Retained Earnings 21,650 Total Stockholders' Equity 27,650 Total Liabilities and Stockholders' Equity 31,650$




Cash Flows from Operating ActivitiesCash Receipts from Customers 89,000$ Cash Payments for Supplies (400)$ Cash Payments for Insurance (1,200) Cash Payments for Operating Expenses (28,000) (29,600) Net Cash Flows from Operating Activities 59,400$ Cash Flows for Investing ActivitiesCash Outflow to Purchase Land (3,000) Cash Flows from Financing ActivitiesCash Receipts from Issuing Common Stock 5,000$ Cash Payment for Dividends (70,000) Net Cash Flows from Financing Activities (65,000) Net Increase in Cash (8,600) Plus Beginning Cash Balance 11,000 Ending Cash Balance 2,400$



Third Accounting Cycle Event 1 Acquired additional $1,000 cash from issuing common stock. Event 2 Sold the land for $2,500 cash. Event 3 Paid $400 cash for more supplies. Event 4 Borrowed $20,000 from a local bank on February 1, 2006. The note

issued had a 9 percent interest rate and a one-year term. Event 5 Paid $1,200 cash to renew the insurance policy for a one-year term

beginning February 1, 2006. Event 6 Recognized revenue for $167,000 of services provided on account. Event 7 Collected $129,000 of the receivables due from customers. Event 8 Recognized $62,000 of accrued operating expenses, other than supplies

and insurance, charged on account. Event 9 Paid suppliers $65,000 of the amount owed on accounts payable. Event 10 Received $18,000 cash in advance from a customer for marketing

services to be performed for a one-year period beginning December 1, 2006.

Event 11 Paid an $80,000 cash dividend to stockholders.

Event 12 Recognized one-month of the unearned revenue. Event 13 Recognized 2006 depreciation expense. Event 14 Recognized supplies expense; $200 of supplies was on hand at the close

of business on December 31, 2006. Event 15 Recognized insurance expense for 12 months. Event 16 Recognized accrued interest on the bank note.

Adjusting Entries

MMI experienced the following transactions during 2006:

Let’s focus

on Event 2 and Event

16.

Event 2: Sold the land for $2,500 cash.

1. Decrease assets (land).



Asset Exchange

Transaction

Gains and Losses

Book Value < Cash = GainBook Value > Cash = Loss

Event 16: Recognized the accrued interest on the bank note.

1. Increase liabilities (interest payable).


Claims Exchange

Transaction

Principal

Annual interest

rate Time

outstanding = Interest

expense

20,000$ 0.09 11/12 = 1,650$

Ledger Accounts= +

Bal. 2,400 Bal. 100 Bal. 4,000 Bal. 6,000 (16) (1,650) (1) 1,000 (5) 1,200 (8) 62,000 (1) 1,000 (2) 2,500 (15) (1,200) (9) (65,000) Bal. 7,000

(3) (400) Bal. 100 Bal. 1,000 (2) (500)

(4) 20,000 (5) (1,200) Bal. 21,650 (7) 129,000 Bal. 12,000 Bal. - (11) (80,000) (9) (65,000) (10) 18,000 (10) 18,000 (12) (1,500) (6) 167,000 (11) (80,000) Bal. 16,500 (12) 1,500

Bal. 26,300 Bal. 168,500

Bal. (5,000) (13) (2,500) (16) 1,650

Bal. 19,000 Bal. (7,500) (8) (62,000)

(6) 167,000 (7) (129,000) (4) 20,000 Bal. 57,000 Bal. 3,000 (13) (2,500)

(2) (3,000) Bal. -

Bal. 150 (14) (350) (3) 400 (13) (350) Bal. 200 (15) (1,200)

LiabilitiesCash Accounts Payable Common Stock

AssetsInterest Expense

Loss on Sale of Land

DividendsRetained Earnings

Supplies

Prepaid Insurance

Accounts Receivable

Stockholders' Equity

Computer Equipment

Accumulated Depr.

Land

Unearned Revenue

Service Revenue

Interest Payable

Notes Payable

Insurance Exp.

Operating Expenses

Depreciation Exp.

Supplies Expense

Now, let’s prepare the 2006 financial

statements.


Service Revenue 168,500$ Operating Expenses 62,000$ Depreciation Expense 2,500 Supplies Expense 350 Insurance Expense 1,200 Total Expenses (66,050) Operating Income 102,450 Less: Interest Expense (1,650) Less: Loss on Sale of Land (500) Net Income 100,300$

Beginning Common Stock 6,000$ Plus: Common Stock Issued 1,000 Ending Common Stock 7,000$ Beginning Retained Earnings 21,650$ Plus: Net Income 100,300 Less: Dividends (80,000) Ending Retained Earnings 41,950 Total Stockholders' Equity 48,950$




AssetsCash 26,300$ Accounts Receivable 57,000 Supplies 200 Prepaid Insurance 100 Computer Equipment 12,000$ Less: Accumulated Depreciation (7,500) 4,500 Total Assets 88,100$

LiabilitiesAccounts Payable 1,000$ Unearned Revenue 16,500 Interest Payable 1,650 Notes Payable 20,000 Total Liabilities 39,150$ Stockholders' EquityCommn Stock 7,000$ Retained Earnings 41,950 Total Stockholders' Equity 48,950 Total Liabilities and Stockholders' Equity 88,100$




Cash Flows from Operating ActivitiesCash Receipts from Customers 147,000$ Cash Payments for Supplies (400)$ Cash Payments for Insurance (1,200) Cash Payments for Operating Expenses (65,000) (66,600) Net Cash Flows from Operating Activities 80,400$ Cash Flows for Investing ActivitiesCash Receipt from Sale of Land 2,500 Cash Flows from Financing ActivitiesCash Receipt from Bank Loan 20,000$ Cash Receipts from Issuing Common Stock 1,000 Cash Payment for Dividends (80,000) Net Cash Flows from Financing Activities (59,000) Net Increase in Cash 23,900 Plus Beginning Cash Balance 2,400 Ending Cash Balance 26,300$



Return on Assets Ratio

Net IncomeTotal Assets

Evaluating performance requires considering the size of the

investment base used to produce the income.

This ratio measures the relationship between the level of income and the size of the investment. A larger ratio means the company did a better job

of managing its assets.

Debt to Assets Ratio

Total DebtTotal Assets

Borrowing money is risky business. This ratio helps evaluate the level of

debt risk.

A smaller ratio indicates that there is less debt risk for the company.

Return on Equity Ratio

Net IncomeStockholders’

Equity

Owners are interested in this ratio to determine their return on their

investment in the company.

A larger ratio indicates that the owners have a higher return on their

investment.

Stockholders like a lot of debt if the company can

take advantage of positive financial

leverage.

Creditors prefer less debt and more equity because equity represents a buffer

of protection.

Stockholders vs. Creditors

End of Chapter Three

©the mcgraw-hill companies, inc. 2006mcgraw-hill/irwin chapter three accounting for deferrals

Documents

na na nanana

net incomecash flowna

unearned revenue common

computer equipment

net incomecash flow72

net incomecash flow50

net incomecash flow12

depreciation expense