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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.
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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. • Increase assets (cash). • Increase stockholders’ equity (common stock). Asset Source Transaction
Event 2: During 2004, Conner Consultants provided $84,000 of consulting services to its clients but no cash has been collected. • Increase assets (accounts receivable). • Increase stockholders’ equity (retained earnings). Asset Source Transaction
Event 3: Conner collected $60,000 cash from customers in partial settlement of its accounts receivable. • Increase assets (cash). • Decrease assets (accounts receivable). Asset Exchange Transaction
Event 4: The instructor earned a salary of $16,000. No cash has yet been paid to the employee. • Increase liabilities (salaries payable). • Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction
Event 5: Conner paid $10,000 to the instructor in partial settlement of salaries payable. • Decrease assets (cash). • Decrease liabilities (salaries payable). Asset Use Transaction
Event 6: Conner paid $2,000 for advertising costs. The advertisements appeared in 2004. • Decrease assets (cash). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction
Event 7: Conner signed contracts for $42,000 of consulting services to be performed in 2005.
Summary of Transactions Now, let’s prepare the financial statements for Conner Consulting using the data presented above. 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
The Closing Process Transfers net income (or loss) and dividends to Retained Earnings. Establishes zero balances in all revenue, expense, and dividend accounts.
Revenues Assets TemporaryAccounts Permanent Accounts Equity Liabilities Dividends Expenses Permanent accounts track financial results from year to year. Temporary and Permanent Accounts Temporary accounts track financial results for a limited period of time.
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 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 objective of accrual accounting is to improve matching of revenues with expenses.
Second Accounting Cycle Assume the following events apply to Conner Consultants during 2005. Since you are familiar with these types of events, let’s look at the summary of the general ledger accounts for Conner Consultants. 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). • Decrease assets (cash). • Increase assets (certificate of deposit). Asset Exchange Transaction 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. • Increase assets (interest receivable). • Increase stockholders’ equity (retained earnings). Asset Source Transaction
Adjusting Entries Update account balances Prior to preparing financial statements
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.
Close Nominal Accounts Adjust Accounts Prepare Statements Steps in an Accounting Cycle Record Transactions 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. Asset Source Transaction • Increase assets (cash). • Increase liabilities (notes payable). 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. • Increase liabilities (interest payable). • Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction
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. Asset Use Transaction • Decrease assets (cash). • Decrease liabilities (interest payable).
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. Asset Use Transaction • Decrease assets (cash). • Decrease liabilities (notes payable).
CPAs Certified Public Accountants The Financial Analyst How can a financial analyst know that a company really did follow GAAP? Audits
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.
Types of Audit Opinions Unqualified Adverse Qualified Disclaimer
Importance of Ethics Code of Conduct Sarbanes-Oxley Act of 2002 Internal Controls
