©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Three Accounting for Deferrals

Deferral Accounting A 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 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, Increase assets (cash). 2.Increase liabilities (unearned revenue). Asset Source Transaction

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

Event 4: MMI paid $12,000 cash to purchase computer equipment. 1.Increase assets (computer equipment). 2.Decrease assets (cash). Asset Exchange Transaction

Event 5: MMI adjusted its accounts to recognize the revenue earned in Decrease liabilities (unearned revenue). 2.Increase stockholders’ equity (retained earnings). Claims Exchange Transaction

Event 6: MMI adjusted its accounts to recognize the expense of using the computer equipment during 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

Accumulated Depreciation and Book Value Accumulated Depreciation Contra Asset Account

Event 7: MMI paid a $50,000 cash dividend to the stockholders. 1.Decrease assets (cash). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

Ledger Accounts Now, let’s prepare the financial statements for MMI using the data presented above.

Preparing Financial Statements

The Matching Concept Three 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 Supplies Prepaid Insurance Prepaid Rent Cost Expense Asset

Second Accounting Cycle 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, Decrease assets (supplies). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

Event 13: Recognized insurance expense for 11 months. 1.Decrease assets (prepaid insurance). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction Now, let’s look at the summary of the ledger accounts at the end of 2005.

Now, let’s prepare the 2005 financial statements.

Preparing Financial Statements

Third Accounting Cycle Let’s focus on Event 2 and Event 16.

Event 2: Sold the land for $2,500 cash. 1.Decrease assets (land). 2.Increase assets (cash). 3.Decrease stockholders’ equity (retained earnings). Asset Exchange Transaction Gains and Losses

Event 16: Recognized the accrued interest on the bank note. 1.Increase liabilities (interest payable). 2.Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction

Ledger Accounts Now, let’s prepare the 2006 financial statements.

Preparing Financial Statements

Return on Assets Ratio Net Income Total 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 Debt Total 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 Income Stockholders’ 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