Chapter Two Accounting for Accruals and Deferrals Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2-1 Cash Basis vs. Accrual Accounting RecognitionRealization Formally recording an economic item or event in the financial statements Collecting cash, generally from the sale of products or services

2-2 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.

2-3 Event 1: Cato Consultants was started on January 1, 2013, when it acquired $5,000 cash by issuing common stock. Asset Source Transaction 1.Increase assets (Cash). 2.Increase stockholders’ equity (Common Stock).

2-4 Event 2: During 2013, Cato 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

2-5 Event 3: Cato 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

2-6 Event 4: Cato paid the instructor $10,000 cash for teaching training courses (salary expense). 1.Decrease cash (assets). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

2-7 Event 5: Cato paid $2,000 for advertising costs. The advertisements appeared in Decrease assets (cash). 2.Decrease stockholders’ equity (retained earnings). Asset Use Transaction

2-8 Event 6: Cato signed contracts for $42,000 of consulting services to be performed in Not recognized in the 2013 financial statements

2-9 Event 7: At the end of 2013, Cato recorded accrued salary expense of $6,000 (the salary expense is for courses the instructor taught in 2013 that Cato will pay cash for in 2014). 1.Increase liabilities (salaries payable). 2.Decrease stockholders’ equity (retained earnings). Claims Exchange Transaction

102- Vertical Statements Model

112- Comparing Cash Flow from Operating Activities with Net Income

2-12 The Closing Process Transfers net income (or loss) and dividends to Retained Earnings. Establishes zero balances in all revenue, expense, and dividend accounts.

2-13 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.

2-14 Steps in an Accounting Cycle Record Transactions Adjust Accounts Prepare Statements Close Nominal Accounts

2-15 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.

The Conservatism Principle 2-16 When faced with a recognition dilemma, conservatism guides accountants to select the alternative that produces the lowest amount of net income.

2-17 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.

2-18 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.

2-19 AICPA Code of Professional Conduct 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 (SOX) 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 2-20

2-21 The Fraud Triangle RationalizationPressure Opportunity Key to protecting yourself and your company: personal integrity.

2-22 Asset cost – Salvage Value Estimating Straight-Line Depreciation Useful Life = Depreciation ($43,000 - $3,000) 4 years = $10,000 per year The asset account, Forklift, is not decreased directly as a result of depreciation. Instead, the asset reduction is recorded in a contra asset account called Accumulated Depreciation.

2-23 Calculating Interest 1.Increase liabilities (Interest Payable). 2.Decrease stockholders’ equity (Retained Earnings). Claims Exchange Event

2-24 End of Chapter Two