Chapter 2 Accounting for Accruals and Deferrals Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2-1 Cash Basis vs. Accrual Accounting RecognitionRealization Formally recording an economic item or event in the financial statements Collecting cash, generally from the sale of products or services

2-2 SECTION 1: SHOW HOW ACCRUALS AFFECT FINANCIAL STATEMENTS Show how receivables affect financial statements. LO 1:

2-3 Event 1: Cato Consultants was started on January 1, 2013, when it acquired $5,000 cash by issuing common stock. Asset Source Transaction 1.Increase assets (Cash). 2.Increase stockholders’ equity (Common Stock).

2-4 Event 2: During 2013, Cato 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

2-5 Event 3: Cato 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

2-6 Event 4: Cato paid the instructor $10,000 cash for teaching training courses (salary expense). 1.Decrease cash (assets). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

2-7 Event 5: Cato paid $2,000 for advertising costs. The advertisements appeared in Decrease assets (cash). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

2-8 Event 6: Cato signed contracts for $42,000 of consulting services to be performed in Not recognized in the 2013 financial statements

2-9 SECTION 1: SHOW HOW ACCRUALS AFFECT FINANCIAL STATEMENTS Show how payables affect financial statements. LO 2

2-10 Event 7: At the end of 2013, Cato recorded accrued salary expense of $6,000 (the salary expense is for courses the instructor taught in 2013 that Cato will pay cash for in 2014). 1.Increase liabilities (salaries payable). 2.Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction

112- Vertical Statements Model

122- Comparing Cash Flow from Operating Activities with Net Income

2-13 The Closing Process Transfers net income (or loss) and dividends to Retained Earnings. Establishes zero balances in all revenue, expense, and dividend accounts.

2-14 Temporary accounts track financial results for a limited period of time. Temporary and Permanent Accounts Revenues Expenses Dividends Temporary Accounts Permanent Accounts Assets Liabilities Equity Permanent accounts track financial results from year to year.

2-15 Steps in an Accounting Cycle Record Transactions Adjust Accounts Prepare Statements Close Nominal Accounts

2-16 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.

The Conservatism Principle 2-17 When faced with a recognition dilemma, conservatism guides accountants to select the alternative that produces the lowest amount of net income.

2-18 Event 1: Cato paid $6,000 to the instructor to settle the salaries payable obligation. 1.Decrease cash (assets). 2.Decrease liabilities (salaries payable). Asset Use Transaction

2-19 SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS Show how supplies affect financial statements. LO 3

2-20 Event 2: Cato purchased $800 of supplies on account. 1.Increase assets (supplies). 2.Increase liabilities (accounts payable). Asset Source Transaction

2-21 SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS Show how prepaid items affect financial statements. LO 4

2-22 Event 3: On March 1, 2014, Cato signed a one-year lease agreement and paid $12,000 cash in advance to rent office space. The one-year lease term begins March 1. 1.Decrease assets (cash). 2.Increase assets (prepaid rent). Asset Exchange Transaction

2-23 SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS Show how unearned revenues affect financial statements. LO 5

2-24 Event 4: Cato received $18,000 cash in advance from Westberry Company for consulting services to be performed over a one-year period beginning June 1, Increase assets (cash). 2.Increase liabilities (unearned revenue). Asset Source Transaction

2-25 Event 5: Cato provided $96,400 of consulting services on account. 1.Increase assets (accounts receivable). 2.Increase stockholders’ equity (retained earnings). Asset Source Transaction

2-26 Event 6: Cato collected $105,000 cash from customers in partial settlement of its accounts receivable. 1.Increase assets (cash). 2.Decrease assets (accounts receivable). Asset Exchange Transaction

2-27 Event 7: Cato paid $32,000 cash for salary expense. 1.Decrease cash (assets). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

2-28 Event 8: Cato incurred $21,000 of other operating expenses on account. 1.Increase liabilities (accounts payable). 2.Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction

2-29 Event 9: Cato paid $18,200 cash in partial settlement of accounts payable. 1.Decrease assets (cash). 2.Decrease liabilities (accounts payable). Asset Use Transaction

2-30 Event 10: Cato paid $79,500 for land it planned to use in the future as a building site for its home office. 1.Decrease assets (cash). 2.Increase assets (land). Asset Exchange Transaction

2-31 Event 11: Cato paid $21,000 in cash dividends to its stockholders. 1.Decrease assets (cash). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

2-32 Event 12: Cato acquired $2,000 cash from issuing additional shares of common stock. Asset Source Transaction 1.Increase assets (Cash). 2.Increase stockholders’ equity (Common Stock).

2-33 SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS Explain the accounting cycle including adjustments and the closing process. LO 6

2-34 Event 13: After determining through a physical count that it had $150 of unused supplies on hand as of December 31, Cato recognized supplies expense. 1.Decrease assets (supplies). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction Beginning supplies balance $0 + Supplies purchased $800 = Supplies available for use $800 - Ending supplies balance $150 = Supplies used $650

2-35 Event 14: Cato recognized rent expense for the office space used during the accounting period. 1.Decrease assets (prepaid rent). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

2-36 Event 15: Cato recognized the portion of the unearned revenue it earned during the accounting period. 1.Decrease liabilities (unearned revenue). 2.Increase stockholders’ equity (retained earnings). Claims Exchange Transaction

2-37 Event 16: Cato recognized $4,000 of accrued salary expense. 1.Increase liabilities (salaries payable). 2.Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction

2-38 SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS Prepare financial statements based on accrual accounting. LO 7

2-39 Preparing Financial Statements

2-40 Preparing Financial Statements

2-41 Preparing Financial Statements

2-42 SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS Classify accounting events into one of four categories: ■ Asset source ■ Asset use ■ Asset exchange ■ Claims exchange LO 8

2-43 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 Claims exchange Increase one claims account, decrease another.

2-44 SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS Discuss the primary components of corporate governance. LO 9

2-45 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.

2-46 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.

2-47 AICPA Code of Professional Conduct 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 (SOX) 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 2-48

2-49 The Fraud Triangle RationalizationPressure Opportunity Key to protecting yourself and your company: personal integrity.

2-50 APPENDIX Compute interest expense and show how it affects financial statements. LO 11

Calculating Interest 1.Increase liabilities (Interest Payable). 2.Decrease stockholders’ equity (Retained Earnings). Claims Exchange Event 2-51

2-52 End of Chapter Two