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Chapter Two. Accruals and Deferrals. 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 Cato Consultants. Learning Objective 1.
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Chapter Two Accruals and Deferrals
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 Cato Consultants.
Learning Objective 1 • Record basic accrual and deferral events in a horizontal financial statements model.
Increase assets (cash). • Increase stockholders’ equity (common stock). Asset Source Transaction Event 1: Cato Consultants was started on January 1, 2008, when it acquired $5,000 cash by issuing common stock.
Increase assets (accounts receivable). • Increase stockholders’ equity (retained earnings). Asset Source Transaction Event 2: During 2008, Cato Consultants provided $84,000 of consulting services to its clients but no cash has been collected.
Increase assets (cash). • Decrease assets (accounts receivable). Asset Exchange Transaction Event 3: Cato collected $60,000 cash from customers in partial settlement of its accounts receivable.
Decrease assets (cash). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction Event 4: Cato paid $10,000 to the instructor for teaching training courses (salary expense).
Decrease assets (cash). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction Event 5: Cato paid $2,000 for advertising costs. The advertisements appeared in 2008.
Event 6: Cato signed contracts for $42,000 of consulting services to be performed in 2009.
Increase liabilities (salaries payable). • Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction Event 7: At the end of 2008, Cato recorded $6,000 accrued salary expense (salary expense for courses the instructor taught in 2008 that Cato will pay him for in 2009).
Summary of Transactions 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 Now, let’s look at the Ledger for Cato Consulting using the data presented above.
Learning Objective 2 • Organize general ledger accounts under an accounting equation.
Learning Objective 3 • Prepare financial statements based on accrual accounting.
Learning Objective 4 • Describe the closing process, the accounting cycle, and the matching concept.
The Closing Process Transfers net income (or loss) and dividends to Retained Earnings. Establishes zero balances in all revenue, expense, and dividend accounts.
Temporary and Permanent Accounts Revenues Assets TemporaryAccounts Permanent Accounts Equity Liabilities Dividends Expenses Permanent accounts track financial results from year to year. Temporary accounts track financial results for a limited period of time.
General Ledger Accounts Here are the general ledger accounts for Cato 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
Steps in an Accounting Cycle Close Temporary Accounts Adjust Accounts Prepare Statements Record Transactions
Conservatism Principle • In uncertain circumstances, conservatism guides accountants to select the alternative that produces the lowest amount of net income. Reporting lower net income now causes investors to respond more favorably if net income is later found to be higher than first reported.
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.
Learning Objective 6 • Explain how business events affect financial statements over multiple accounting cycles.
Second Accounting Cycle Assume the following events apply to Cato Consultants during 2009.
Decrease assets (cash). • Decrease liabilities (salaries payable). Asset Use Transaction Event 1: Cato paid $6,000 to the instructor to settle the salaries payable obligation. Operating Activity
Prepaid Expenses Cost Asset Expense Deferred Expense Expense Supplies Prepaid Insurance Prepaid Rent
Decrease assets (cash). • Increase assets (prepaid rent). Asset Exchange Transaction Event 2: On March 1, Cato signed a one-year lease and paid $12,000 cash in advance. The lease began on March 1. Operating Activity
Increase assets (cash). • Increase liabilities (unearned revenue). Asset Source Transaction Event 3: Cato received from Westberry Company $18,000 cash in advance for consulting services Cato agreed to perform over a one-year period beginning June 1. Operating Activity
Increase assets (supplies). • Increase liabilities (accounts payable). Asset Source Transaction Event 4: Cato purchased $800 of supplies on account.
Increase assets (accounts receivable). • Increase stockholders’ equity (retained earnings). Asset Source Transaction Event 5: Cato provided $96,400 of consulting services on account.
Increase assets (cash). • Decrease assets (accounts receivable). Asset Exchange Transaction Operating Activity Event 6: Cato collected $105,000 cash from customers as partial settlement of accounts receivable.
Decrease assets (cash). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction Operating Activity Event 7: Cato paid $32,000 cash for salary expense.
Increase liabilities (accounts payable). • Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction Event 8: Cato incurred $21,000 of other operating expenses on account.
Decrease assets (cash). • Decrease liabilities (accounts payable). Asset Use Transaction Operating Activity Event 9: Cato paid $18,200 in partial settlement of accounts payable.
Decrease assets (cash). • Increase assets (land). Asset Exchange Transaction Investing Activity Event 10: Cato paid $79,500 to purchase land it planned to use in the future as a building site for its home office.
Decrease assets (cash). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction Financing Activity Event 11: Cato paid $21,000 in cash dividends to its stockholders.
Increase assets (cash). • Increase stockholders’ equity (common stock). Asset Source Transaction Financing Activity Event 12: Cato acquired $2,000 cash from issuing additional shares of common stock.
Adjusting Entries Update account balances Prior to preparing financial statements
Decrease assets (supplies). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction Event 13: Recognized supplies expense; $150 of supplies were on hand at the close of business on December 31, 2009.
Decrease assets (prepaid insurance). • Decrease stockholders’ equity (retained earnings). Asset Use Transaction Event 14: Cato recognized rent expense for the office space used during the accounting period.
Decrease liabilities (unearned revenue). • Increase stockholders’ equity (retained earnings). Claims Exchange Transaction Event 15: Cato recognized the portion of the unearned revenues it earned during the accounting period.
Increase liabilities (salaries payable). • Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction Event 16: Cato recognized $4,000 of accrued salary expense.
Summary of General Ledger Accounts Here is a summary of the general ledger accounts for Cato Consulting at December 31, 2009.
Ledger Accounts Now, let’s prepare the 2009 financial statements for Cato using the data presented above.
