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