Accounting for Accruals

Accounting for Accruals
Chapter Two Accounting for Accruals Cash basis accounting recognizes revenues and expenses in the period in which the cash is collected or paid. In contrast, accrual accounting recognizes revenues and expenses in the period in which they occur regardless of when cash is collected or paid. In this chapter, we will learn more about accrual accounting.

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. 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.

Asset Source Transaction
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 Part I Event one: Conner Consultants was started on January 1st, 2004, when it acquired five thousand dollars cash by issuing common stock. Part II This transaction increases the cash asset account and increases the common stock stockholders’ equity account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model.

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 Part I Event two: During 2004, Conner Consultants provided eighty four thousand dollars of consulting services to its clients but no cash has been collected. This type of transaction is frequently referred to as providing services on account. Part II This transaction increases the accounts receivable asset account and increases the retained earnings stockholders’ equity account. It is classified as an asset source transaction. Accrual accounting requires companies to recognize revenue in the period in which the work is done regardless of when cash is collected. Part III Here is the effect of this transaction on the financial statements model. Notice that the event affects the balance sheet and the income statement but not the statement of cash flows since cash was not collected as part of this transaction.

Asset Exchange 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 Part I Event three: Conner collected sixty thousand dollars cash from customers in partial settlement of its accounts receivable. Part II This transaction increases the cash asset account and decreases the accounts receivable asset account. It is classified as an asset exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Notice that the event affects the statement of cash flows since cash was collected as part of this transaction.

Claims 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 Part I Event four: The instructor earned a salary of sixteen thousand dollars. No cash has yet been paid to the employee. Part II This transaction increases the salaries payable liability account and decreases the retained earnings stockholders’ equity account. It is classified as a claims exchange transaction. Accrual accounting requires companies to recognize expenses in the period in which they are incurred regardless of when cash is paid. Part III Here is the effect of this transaction on the financial statements model. Notice that the event affects the balance sheet and the income statement but not the statement of cash flows since cash was not paid as part of this 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 Part I Event five: Conner paid ten thousand dollars to the instructor in partial settlement of salaries payable. Part II This transaction decreases the cash asset account and decreases the salaries payable liability account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model.

Event 6: Conner paid $2,000 for advertising costs
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 Part I Event six: Conner paid two thousand dollars for advertising costs. The advertisements appeared in 2004. Part II This transaction decreases the cash asset account and decreases the retained earnings stockholders’ equity account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model.

Event 7: Conner signed contracts for $42,000 of consulting services to be performed in 2005.
Part I Event seven: Conner signed contracts for forty two thousand dollars of consulting services to be performed in 2005. Part II Because this event is just the signing of a contract, it does not affect any of the financial statement model.

Summary of Transactions
Part I Here is a summary of the transactions we just looked at for Conner Consulting. Take a few minutes and make sure you understand each transaction’s impact on the financial statements model. Part II The amounts in this summary are color coded as follows: Data in green appear on the statement of cash flows. Data in red appear on the balance sheet. Data in blue appear on the income statement. Part III 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 Now, let’s prepare the financial statements for Conner Consulting using the data presented above.

Preparing Financial Statements
Here is the income statement and statement of stockholders’ equity for Conner Consultants. We need to take a minute and redefine expenses as we look at this statement. In chapter one, expenses were defined as assets and services consumed in the process of generating revenue. In the Conner illustration, no assets were consumed when the salaries expense was recognized. Instead of a decrease in assets, Conner recorded an increase in liabilities (salaries payable). In the expanded form, expenses can be defined as decreases in assets or increases in liabilities resulting from consuming assets and services to generate revenue. Similarly, revenue can be defined as increases in assets or decreases in liabilities from providing goods or services to customer in the normal course of operations. We will look at specific examples of revenue in the next chapter.

Here is the balance sheet for Conner Consultants. It discloses an entity’s assets, liabilities, and stockholders’ equity at a particular point in time.

Here is Conner Consultants statement of cash flows. It explains the change in cash from the beginning of the accounting period to the end of the accounting period. It can be prepared by analyzing the increases and decreases in the cash account. Notice that the amount of cash flows from operations of forty eight thousand dollars is different from the sixty six thousand dollars in net income reported on the income statement we saw earlier. The difference results from the fact that some revenue was earned on account and some expenses were recognized on account. Avoid the misconception of many students in their first accounting class who confuse revenue and expenses as equivalent with cash.

Transfers net income (or loss) and dividends to Retained Earnings.
The Closing Process Transfers net income (or loss) and dividends to Retained Earnings. Establishes zero balances in all revenue, expense, and dividend accounts. At the end of the year, closing journal entries are prepared. Closing entries serve two purposes. First, they transfer net income (or loss) and dividends to Retained Earnings. This process gets the Retained Earnings account balance up to date. Second, they establish zero balances in all income statement and dividend accounts so they are ready to start collecting amounts for the next accounting period.

Temporary and Permanent Accounts
Revenues Expenses Dividends TemporaryAccounts Permanent Accounts Assets Liabilities Equity Permanent accounts track financial results from year to year. Part I Accounts that are closed (revenues, expenses, and dividends) are referred to as temporary accounts. Temporary accounts track financial results for a limited period of time. Part II Accounts that are not closed (assets, liabilities, and equity) are referred to a permanent accounts. Permanent accounts track financial results from year to year. Let’s see how to prepare closing journal entries. 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. Here is a summary of the ledger accounts for Conner Consultants after closing the temporary accounts. Closing entry one transfers the balance in the revenue account to retained earnings. Closing entries two and three transfer the balances in the expense accounts to retained earnings. 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. Part I Accounting systems are designed to record most recurring daily transactions, particularly any involving cash. 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. When this occurs, the matching of revenues and expenses can be difficult when accrual accounting is used. Part II The solution for this timing difference is to record adjusting entries at the end of the period to get the amounts reported as revenues and expenses up to date. Let’s look at an example using the second year transactions for Conner Consultants. 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. Part I Assume the following events apply to Conner Consultants during These six events are conceptually identical to transactions explained previously. Part II The effects of these events on the general ledger accounts are shown on the summary above. If you do not understand these effects, review the previous material. Part III Now, let’s move on to events 7 and 8 which are new to us. 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.

Asset Exchange Transaction
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 Part I Event seven: On March 1, 2005, Conner invested sixty thousand dollars in a certificate of deposit (CD). Part II This transaction decreases the cash asset account and increases the certificate of deposit asset account. It is classified as an asset exchange transaction. Part III Here is the effect of this transaction on the financial statements model. Part IV This transaction is classified as an investing activity on the statement of cash flows because it represents an investment made by Conner. 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 Part I Event eight: On December 31, 2005, Conner adjusted the books to recognize interest revenue earned to date on the CD. The CD had a six percent annual rate of interest and a one-year tem to maturity. Interest is due in cash on the maturity date, March 1, 2006. Part II This transaction increases the interest receivable asset account and increases the retained earnings stockholders’ equity account. It is classified as an asset source transaction. The interest revenue amount is calculated as principal times the annual interest rate times the time outstanding during the accounting period. Part III Here is the effect of this transaction on the financial statements model.

Adjusting Entries Update account balances
Prior to preparing financial statements Adjusting entries help get the account balances up to date before preparing financial statements.

Summary of General Ledger Accounts
Here is a summary of the general ledger accounts for Conner Consulting at December 31, 2005. Here is a summary of all eight transactions for Conner Consultants for 2005. Now, let’s prepare the 2005 financial statements for Conner Consulting using this data. Now, let’s prepare the 2005 financial statements for Conner Consulting using the data presented above.

Here is the income statement and statement of changes in stockholders’ equity for Conner Consultants. Notice again that the net income of seventy seven thousand dollars is not equivalent to the cash balance on the previous slide nor to the cash from operations of eighty two thousand dollars which we will see in a minute on the statement of cash flows. The statement of changes in stockholders’ equity shows the increase in the ownership of the company during the year. It also shows the increase in retained earnings from net income and the decrease from dividends.

Here is the balance sheet for Conner Consultants. Take a minutes and review Conner Consultants’ assets, liabilities and equity accounts.

Here is the statement of cash flows for Conner Consultants. Review of this statement reveals an eighty two thousand dollar cash inflow from operations, a sixty thousand dollar cash outflow for investing activities and a net fifteen thousand dollar cash inflow from financing activities.

Steps in an Accounting Cycle
Record Transactions Adjust Accounts Now, let’s look at some more transactions for Conner Consultants. Close Nominal Accounts Part I Let’s review the steps in the accounting cycle. First, we record transactions during the accounting period. Part II At the end of the accounting period, we make any necessary adjusting entries to get the account balances up to date. Part III Next, we prepare financial statements for the accounting period. Part IV Next, we close the nominal or temporary accounts. Part V Then, we are ready to start recording transactions for the next accounting period. Now, let’s look at some more transactions for Conner Consultants. Prepare Statements

On September 1, 2006, Conner borrowed $90,000 cash from First City Bank by issuing a 1 year note at 9% interest. Increase assets (cash). Increase liabilities (notes payable). Asset Source Transaction Financing Activity Part I On September 1, 2006, Conner borrowed ninety thousand dollars cash from First City Bank by issuing a 1 year note at 9% interest. Part II This transaction increases the cash asset account and increases the notes payable liability account. It is classified as an asset source transaction. Part III Here is the effect of this transaction on the financial statements model. This transaction is classified as a financing activity on the statement of cash flows.

Claims Exchange Transaction
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 Part I On August 31, 2007, the maturity date of the note, three events are recognized. First, five thousand four hundred dollars of interest expense has accrued since January 1, 2007. The interest expense is calculated as principal time the annual interest rate times the time outstanding during the accounting period. Part II This transaction increases the interest payable liability account and decreases the retained earnings stockholders’ equity account. It is classified as a claims exchange transaction. Part III Here is the effect of this transaction on the financial statements model.

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. Decrease assets (cash). Decrease liabilities (interest payable). Asset Use Transaction Part I On August 31, 2007, the maturity date of the note, three events are recognized. Second, cash is paid for eight thousand one hundred dollars, the total amount of interest due on the note. The interest payable is calculated as principal time the annual interest rate times the time outstanding since the last interest payment occurred. Part II This transaction decreases the cash asset account and decreases the interest payable liability account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model.

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. Decrease assets (cash). Decrease liabilities (notes payable). Asset Use Transaction Part I On August 31, 2007, the maturity date of the note, three events are recognized. Third, Conner must recognize the repayment of the ninety thousand dollars principal of the note. Part II This transaction decreases the cash asset account and decreases the notes payable liability account. It is classified as an asset use transaction. Part III Here is the effect of this transaction on the financial statements model.

Vertical Financial Statements
Useful insights can be gained by analyzing financial statements over multiple accounting cycles. A statements model that arranges financial statement information vertically on a single page provides a convenient tool for such analysis. This slide presents a multicycle vertical statements model for Conner Consultants, using 2004 and 2005 accounting data. Using this model you can focus on important interrelationships among the financial statements. For each year, notice how the amount of net income is carried forward from the income statement to the statement of changes in stockholders’ equity. Next, see how the ending balances of common stock and retained earnings appearing on this statement are carried forward to the balance sheet on the next slide.

Notice that the amount of cash reported on the balance sheet agrees with the ending cash balance on the statement of cash flows on the next slide.

Notice that the ending cash balance of fifty three thousand dollars on the 2004 balance sheet agrees with the beginning cash balance shown on the 2005 statement of cash flows.

Certified Public Accountants
The Financial Analyst How can a financial analyst know that a company really did follow GAAP? Audits CPAs Certified Public Accountants Part I How can a financial analyst know that a company really did follow generally accepted accounting principles? Part II Analysts and other users rely on audits conducted by certified public accountants. An audit is a detailed examination of a company’s financial statements and underlying accounting records. The primary roles of an independent auditor are: Conducts a financial audit. Assumes both legal and professional responsibilities to the public as well as to the company paying the auditor. Determines if financial statements are materially correct rather than absolutely correct. Presents conclusions in an audit report that includes an opinion as to whether the statements are prepared in conformity with generally accepted accounting principles. Maintains professional confidentiality of client records. However, this does not exempt the auditor from legal obligations such as testifying in court.

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. Part I As mentioned in the primary roles of auditors on the previous slide, auditors do not guarantee that financial statements are absolutely correct—only that they are materially correct. The question then becomes “How big is material?”. The concept of materiality is very subjective. If Wal-Mart inadvertently overstated its sales by one million dollars, would this be material? In 2002, Wal-Mart had approximately two hundred forty five million dollars of sales! A one million dollar error in sales at Wal-Mart is like a one dollar error in computing the pay of a person who makes two hundred forty five thousand dollars a year—not material at all! Part II An error, or other reporting problem, is material if knowing about it would influence the decision of an average prudent investor.

Types of Audit Opinions
Unqualified Adverse Part I Once an audit it complete, the auditors present their conclusions in a report that includes an audit opinion. If auditors are satisfied that the financial statements are “fair”, they issue an unqualified audit report. An unqualified audit report indicates that the financial statements are useful and that creditors and investors can trust what is reported. Part II The most negative report an auditor can issue is an adverse opinion. An adverse opinion means that one or more departures from Generally Accepted Accounting Principles are so material the financial statements do not present a fair picture of the company’s status. Part III A qualified opinion falls between an unqualified and an adverse opinion. A qualified opinion means that for the most part, the company’s financial statements are in compliance with Generally Accepted Accounting Principles, but the auditors have reservations about something in the statements. The auditor’s report explains why the opinion is qualified. Part IV If an auditor is unable to perform the audit procedures necessary to determine whether the statements are prepared in accordance with Generally Accepted Accounting Principles, the auditor cannot issue an opinion on the financial statements. Instead, the auditor issues a disclaimer of audit opinion. A disclaimer is neither negative nor positive. It simply means that the auditor is unable to obtain enough information to confirm compliance with Generally Accepted Accounting Principles. Qualified Disclaimer

Importance of Ethics Code of Conduct Sarbanes-Oxley Act of 2002
Part I The accountant’s role in society requires trust and credibility. An audit is worthless if the auditor is not trustworthy. The American Institute of Certified Public Accountants requires its members to comply with the Code of Professional Conduct. This code includes statements on accountant’s responsibilities, protecting the public interest, integrity, objectivity and independence, due care and the scope and nature of services. Part II Unfortunately, codes of ethics cannot deter all unethical behavior. The massive surprise bankruptcies of Enron in late 2001 and WorldCom several months later suggested major audit failures on the part of the independent auditors. An audit failure means a company’s auditor does not detect, or fails to report, that the company’s financial statements are not incompliance with Generally Accepted Accounting Principals. In 2002, Congress passed the Sarbanes-Oxley Act. The provisions of this legislation are complex. However, it is clear that the act has tightened the rules governing auditors’ independence. For example, the Sarbanes-Oxley Act prohibits auditors from providing most types of nonaudit services to companies they audit. Another provision of the Act clarifies the legal responsibilities that company management has for a company’s financial statements. For example, the company’s chief executive officer and chief financial officer must certify in writing that they have reviewed the financial reports being issued, and that the reports present fairly the company’s financial status. Part III Accountants establish policies and procedures designed to reduce opportunities for fraud. These policies and procedures are commonly called internal controls. Specific internal controls procedures are tailored to meet the individual needs of particular businesses. For example, banks use vaults to protect cash, but universities have little use for this type of equipment. We will discuss more about internal controls in chapter seven. Internal Controls

End of Chapter Two In this chapter, we learned more about accrual accounting. We also learned about auditors and their role in providing audits that are trustworthy and credible.

Accounting for Accruals

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