© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter Two Accounting for Accruals

2-2 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.

2-3 LO 1 Record basic accrual events in a horizontal financial statements model.

2-4 Event 1: Conner Consultants was started on January 1, 2008, when it acquired $5,000 cash by issuing common stock. 1.Increase assets (cash). 2.Increase stockholders’ equity (common stock). Asset Source Transaction

2-5 Event 2: During 2008, 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 New Event

2-6 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 New Event

2-7 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 Salaries Expense New Event

2-8 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 New Event

2-9 Event 6: Conner paid $2,000 for advertising costs. The advertisements appeared in Decrease assets (cash). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction Advertising Expense

2-10 Event 7: Conner signed contracts for $42,000 of Consultants services to be performed in 2009.

2-11 LO 2 Organize general ledger accounts under an accounting equation.

2-12 Summary of Transactions Now, let’s prepare the financial statements for Conner Consultants using the data presented above.

2-13 LO 3 Prepare financial statements based on accrual accounting.

2-14 Preparing Financial Statements Earned--not all received Incurred not paid

2-15 Preparing Financial Statements

2-16 Preparing Financial Statements

2-17 LO 4 Describe the matching concept, the accounting cycle and the closing process.

2-18 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

2-19 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.

2-20 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

2-21 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.

2-22 LO 5 Record business events involving interest-bearing receivables and payables in a horizontal financial statements model.

2-23 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 Assume the following events apply to Conner Consultants during Now, let’s move on to events 7 & 8.

2-24 Event 7: On March 1, 2009, Conner invested $60,000 in a certificate of deposit (CD). 1.Decrease assets (cash). 2.Increase assets (certificate of deposit). Asset Exchange Transaction Investing Activity

2-25 Event 8: On December 31, 2009, 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 term to maturity. Interest is due in cash on the maturity date, March 1, Increase assets (interest receivable). 2.Increase stockholders’ equity (retained earnings). Asset Source Transaction Interest Revenue

2-26 Adjusting Entries Update account balances Prior to preparing financial statements

2-27 Summary of General Ledger Accounts Here is a summary of the general ledger accounts for Conner Consultants at December 31, Now, let’s prepare the 2009 financial statements for Conner Consultants using the data presented above.

2-28 Preparing Financial Statements

2-29 Preparing Financial Statements equal

2-30 Preparing Financial Statements

2-31 Steps in an Accounting Cycle Record Transactions Adjust Accounts Prepare Statements Close Nominal Accounts Now, let’s look at some more transactions for Conner Consultants

2-32 On September 1, 2010, 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 Financing Activity 4/12 for interest would be calculated in 2010

2-33 On August 31, 2011, the maturity date of the note, three events are recognized. First, $5,400 of interest expense has accrued since January 1, Increase liabilities (interest payable). 2.Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction Interest Expense

2-34 On August 31, 2011, 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

2-35 On August 31, 2011, 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

2-36 LO 6 & 7 Prepare a vertical financial statements model. Explain how business events affect financial statements over multiple accounting cycles

2-37 Vertical Financial Statements Changes in Stockholders’ Equity Statement

2-38 Vertical Financial Statements

2-39 Vertical Financial Statements

2-40 LO 8 Discuss the primary components of corporate governance.

2-41 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.

2-42 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.

2-43 AICPA Code of Professional Ethics 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 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 2-44

2-45 The Fraud Triangle RationalizationPressure Opportunity Key to protecting yourself and your company: personal integrity.

2-46 LO 9 Classify accounting events into one of four categories.

2-47 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.

2-48 LO 10 Appendix: Describe the auditor’s role in financial reporting.

2-49 The Financial Analyst How can a financial analyst know that a company really did follow GAAP? Certified Public Accountants

2-50 Materiality and Financial Audits Auditors do not guarantee that financial statements are absolutely correct—only that they are materially correct. Material Item An error, or other reporting problem, that would influence the decision of an average prudent investor.

2-51 Types of Audit Opinions UnqualifiedAdverse QualifiedDisclaimer

2-52 End of Chapter Two