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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. .
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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. • Increase assets (cash). • 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, 2005. Asset Source Transaction • Increase assets (cash). • Increase liabilities (unearned revenue).
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. Asset Exchange Transaction • Increase assets (computer equipment). • Decrease assets (cash).
Event 5: MMI adjusted its accounts to recognize the revenue earned in 2004. • Decrease liabilities (unearned revenue). • Increase stockholders’ equity (retained earnings). Claims Exchange Transaction
Event 6: MMI adjusted its accounts to recognize the expense of using the computer equipment during 2004. 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. • Decrease assets (accumulated depreciation). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction
Accumulated Depreciation Contra Asset Account Accumulated Depreciation and Book Value
Event 7: MMI paid a $50,000 cash dividend to the stockholders. Asset Use Transaction • Decrease assets (cash). • Decrease stockholders’ equity (retained earnings).
Ledger Accounts Now, let’s prepare the financial statements for MMI using the data presented above.
The Matching Concept • Three Common Matching Practices • Costs may be matched directly with the revenues they generate. • The costs of items with short or undeterminable useful lives are matched with the period in which they are incurred. • The costs of long-term assets with identifiable useful lives are systematically allocated over the assets’ useful lives.
Cost Asset Expense Expense Prepaid Expenses Supplies Prepaid Insurance Prepaid Rent
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, 2005. Asset Use Transaction • Decrease assets (supplies). • Decrease stockholders’ equity (retained earnings).
Event 13: Recognized insurance expense for 11 months. • Decrease assets (prepaid insurance). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction Now, let’s look at the summary of the ledger accounts at the end of 2005.
Third Accounting Cycle Let’s focus on Event 2 and Event 16.
Event 2: Sold the land for $2,500 cash. • Decrease assets (land). • Increase assets (cash). • Decrease stockholders’ equity (retained earnings). Asset Exchange Transaction Gains and Losses
Event 16: Recognized the accrued interest on the bank note. • Increase liabilities (interest payable). • Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction
Ledger Accounts Now, let’s prepare the 2006 financial statements.
Net Income Total Assets Return on Assets Ratio 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.
Total Debt Total Assets Debt to Assets Ratio 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.
Net Income Stockholders’ Equity Return on Equity Ratio 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 vs. Creditors 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.
