1. Chapter 2 Accounting for Accruals and Deferrals
In this chapter, we will learn more about the accounting cycle.

2. SHOW HOW ACCRUALS AFFECT FINANCIAL STATEMENTS
SECTION 1
SHOW HOW ACCRUALS AFFECT FINANCIAL STATEMENTS
SECTION 1: SHOW HOW ACCRUALS AFFECT FINANCIAL STATEMENTS

3. Cash Basis Versus Accrual Accounting
Recognition results in formally recording an economic item or event in the financial statements.
Realization results in collecting cash, generally from the sale of products or services.
Part I
Users of financial statements must distinguish between the terms recognition and realization. Recognition means formally recording an economic item or event in the financial statements. Realization refers to collecting cash, generally from the sale of products or services.
Part II
Users of cash basis accounting recognize revenues and expenses when cash is paid or collected. In contrast, users of accrual basis accounting recognize revenues when earned and expenses when incurred, regardless of when cash is exchanged. Virtually all of the major companies operating in the United States use accrual accounting.
Part III
Let’s demonstrate accrual accounting by describing events that relate to a company named Cato Consultants.

4. LO 2-1: Show how receivables affect financial statements.
Learning Objective 2-1: Show how receivables affect financial statements.

5. Event 1
Cato Consultants was started on January 1, Year 1, when it acquired $5,000 cash by issuing common stock.
This asset source transaction: (1) increases assets (Cash) and (2) increases stockholders’ equity (Common Stock).
Assets =
Liab. +
Stockholders' Equity
Cash
Supplies
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
5,000
n/a FA
Part I
Event 1: Cato Consultants acquired $5,000 cash by issuing Common Stock.
Part II
Here is the effect of this transaction on the financial statements model. Cash, an asset, and stockholders’ equity all increased by $5,000.
Part III
This is considered to be an asset source transaction.

6. Event 2
During Year 1, Cato Consultants provided $84,000 of consulting services to its clients but no cash has been collected.
This asset source transaction: (1) increases assets (Accounts Receivable) and (2) increases stockholders’ equity (Retained Earnings).
Assets =
Liab. +
Stockholders' Equity
Cash
Accts Rec.
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
84,000
Part I
Event 2: During Year 1, Cato 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, because of revenue, 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.

7. Event 3
Cato collected $60,000 cash from customers in partial settlement of its accounts receivable.
This asset exchange transaction: (1) increases assets (Cash) and (2) decreases assets (Accounts Receivable).
Assets =
Liab. +
Stockholders' Equity
Cash
Accts Rec.
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
60,000
(60,000)
n/a OA
Part I
Event 3: Cato collected $60,000 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. The income statement is not affected, but the statement of cash flows reports an inflow for operating activities. 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.

8. Event 4
Cato paid the instructor $10,000 cash for teaching training courses (salary expense).
This asset use transaction: (1) decreases assets (Cash) and (2) decreases stockholders’ equity (Retained Earnings).
Assets =
Liab. +
Stockholders' Equity
Cash
Accts Rec.
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
(10,000)
n/a
10,000 OA
Part I
Event 4: Cato paid the instructor $10,000 to teach the training courses.
Part II
This transaction decreases the Cash asset account and decreases the Retained Earnings stockholders’ equity account. The salaries expense reduces net income, and the statement of cash flows reports an outflow for operating activities. This is classified as an asset use transaction.
Even in accrual accounting, sometimes expenses are recognized at the time that cash is paid, as long as it is the same time that the expense is incurred.
Part III
Here is the effect of this transaction on the financial statements model.

9. Event 5
Cato paid $2,000 for advertising costs. The advertisements appeared in Year 1.
This asset use transaction: (1) decreases assets (Cash) and (2) decreases stockholders’ equity (Retained Earnings).
Assets =
Liab. +
Stockholders' Equity
Cash
Accts Rec.
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
(2,000)
n/a
2,000 OA
Part I
Event 5: Cato paid $2,000 for advertising costs. The advertisements appeared in Year 1.
Part II
This transaction decreases the Cash asset account and decreases the Retained Earnings stockholders’ equity account. The advertising expense will decrease net income. The statement of cash flows reports an outflow for operating activities. This is also classified as an asset use transaction.
Part III
Here is the effect of this transaction on the financial statements model.

10. LO 2-2: Show how payables affect financial statements.
Learning Objective 2-2: Show how payables affect financial statements.

11. Event 6
At the end of Year 1, Cato recorded accrued salary expense of $6,000. The salary expense is for courses the instructor taught in Year 1. However, Cato will not pay the instructor cash until Year 2.
This claims exchange transaction: (1) increases liabilities (Salaries Payable) and (2) decreases stockholders’ equity (Retained Earnings). The entry, required to update account balances, is called an adjusting entry.
Assets =
Liab. +
Stockholders' Equity
Cash
Accts Rec.
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
6,000
(6,000)
Part I
Event 6: At the end of Year 1, Cato recorded accrued salary expense of six thousand dollars. The salary expense is for courses the instructor taught in Year 1. However, Cato will not pay the instructor cash until Year 2.
Part II
This event is a claims exchange transaction. The claims of creditors (Liabilities) increase and the claims of stockholders (Retained Earnings) decrease. Total claims remain unchanged. The salary expense is reported on the income statement. The statement of cash flows is not affected.
Part III
Here is the effect of this transaction on the financial statements model.

12. Event 7
Cato signed contracts for $42,000 of consulting services to be performed in Year 2.
This event is not recognized in the Year 1 financial statements.
Assets =
Liab. +
Stockholders' Equity
Cash
Prepaid Rent
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
Part I
Event 7: Cato signed contracts for $42,000 of consulting services to be performed in Year 2.
Part II
The $42,000 for consulting services to be performed in Year 2 is not recognized in the Year 1 financial statements. Revenue is recognized for work actually completed, not work expected to be completed. This event does not affect any of the financial statements.

13. LO 2-3: Prepare financial statements that include accruals.
Learning Objective 2-3: Prepare financial statements that include accruals.

14. Exhibit 2.2: Vertical Statements Model
The financial statements for Cato Consultants’ Year 1 accounting period are represented in a vertical statements model in Exhibit 2.2. A vertical statements model arranges a set of financial statement information vertically on a single page. Like horizontal statements models, vertical statements models are learning tools. They illustrate interrelationships among financial statements. The models do not, however, portray the full, formal presentation formats companies use in published financial statements. Here is the vertical statements model that captures our previous transactions.
The income statement reflects accrual accounting.
The statement of changes in stockholders’ equity reports the effects on equity of issuing common stock, earning net income, and paying dividends to stockholders.
The balance sheet discloses an entity’s assets, liabilities, and stockholders’ equity at a particular point in time.
The statement of cash flows explains the change in cash from the beginning to the end of the accounting period and is prepared by analyzing the Cash account.

15. Comparing Cash Flow from Operating Activities with Net Income
Accrual Accounting
Cash Flow
Consulting Revenue
$84,000
$60,000
Salary Expense
(16,000)
(10,000)
Advertising Expense
(2,000)
Net income
$66,000
$48,000
Note that the amount of net income measured using accrual accounting differs from the amount of cash flow from operating activities. For Cato Consulting in Year 1, the differences are summarized in this slide. The Cato illustration demonstrates that a company may recognize a revenue or expense without a corresponding cash collection or payment in the same accounting period.

16. LO 2-4: Identify the steps in the accounting cycle.
Learning Objective 2-4: Identify the steps in the accounting cycle.

17. The Closing Process
The closing process accomplishes two important functions:
It transfers net income (or loss) and dividends to Retained Earnings.
It 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.

18. Temporary and Permanent Accounts
Temporary Accounts include:
Permanent Accounts include:
Expenses
Assets
Revenues
Liabilities
Dividends
Equity
Temporary accounts track financial results for a limited period of time. 
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
Balance sheet accounts (assets, liabilities, and equity) are referred to as permanent accounts, and they are not closed. The amounts in these accounts will carry forward into the next accounting period.

19. Steps in an Accounting Cycle
You can imagine the accounting cycle as a circle that begins with: (1) Recording transactions, then (2) Adjusting accounts in order to (3) Prepare statements, and finally (4) Close Nominal or temporary accounts in order to start the accounting process all over again for the next accounting period.
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.

20. 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.
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. Cash basis accounting can distort reported net income because it sometimes fails to match expenses with the revenues they produce.
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. Expenses that are matched with the period in which they are incurred are frequently called period costs.

21. SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS
SECTION 2
SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS
SECTION 2: SHOW HOW DEFERRALS AFFECT FINANCIAL STATEMENTS

22. LO 2-5: Show how accounting for supplies affects financial statements.
Learning Objective 2-5: Show how accounting for supplies affects financial statements.

23. Second Accounting Cycle: Event 1
Cato pays $6,000 to the instructor to settle the salaries payable obligation.
This asset use transaction: (1) decreases assets (Cash) and (2) decreases liabilities (Salaries Payable).
Assets =
Liab. +
Stockholders' Equity
Cash
Accts. Rec.
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
(6,000)
n/a OA
Second Accounting Cycle: Now we will turn our attention to the effects of Cato Consultants’ Year 2 events.
Part I
Event 1: Cato paid $6,000 to the instructor to settle the salaries payable obligation.
Part II
When Cato pays the instructor, both the asset account Cash and the liability account Salaries Payable decrease. This is classified as an asset use transaction.
The cash payment does not affect the income statement. The salary expense was recognized in Year 1 when the instructor taught the classes. The statement of cash flows reflects a cash outflow from operating activities.
Part III
Here is the effect of this transaction on the financial statements model.

24. Second Accounting Cycle: Event 2
Cato purchased $800 of supplies on account.
This asset source transaction: (1) increases assets (Supplies) and (2) increases liabilities (accounts payable).
Assets =
Liab. +
Stockholders' Equity
Cash
Supplies
AccountsPayable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
800
Part I
Event 2: Cato purchased $800 of supplies on account.
Part II
The asset account Supplies and the liability account Accounts Payable increase. The income statement is unaffected. Expense recognition is deferred until the supplies are used. The statement of cash flows is not affected.
Part III
Here is the effect of this transaction on the financial statements model.

25. Adjustment 1
After determining through a physical count that it had $150 of unused supplies on hand as of December 31, Cato recognized supplies expense.
The result of this asset use transaction is that it is recorded in two places: (1) as a decrease in assets (Supplies) and (2) as a decrease in stockholders’ equity (Retained Earnings).
Beginning
Supplies Balance, $0 +
Supplies
Purchased, $800 =
Supplies available for use, $800 −
Ending Supplies Balance,
$150
Used, $650
Assets =
Liab. +
Stockholders' Equity
Cash
Supplies
Accounts Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
(650)
650
Part I
Year-End Adjusting Entry 1: After determining through a physical count that it had $150 of unused supplies on hand as of December 31, Cato recognized supplies expense.
Part II
Companies would find it impractical to record expense each time an individual supply is used. Instead, they record supplies expense at the end of the year by determining the total quantity of supplies used.
Part III
To calculate the quantity of supplies used, add together the beginning supplies balance and supplies purchased to determine supplies available for use. Then, subtract the ending supplies balance to determine supplies used. Cato used $650 of supplies during the year; therefore, that is the supplies expense that it will record. This is an asset use transaction.
Part IV
Here is the effect of this transaction on the financial statements model.

26. LO 2-6: Show how accounting for prepaid items affects financial statements.
Learning Objective 2-6: Show how accounting for prepaid items affects financial statements.

27. Second Accounting Cycle: Event 3
On March 1, Year 2, Cato signed a one-year lease agreement and paid $12,000 cash in advance to rent office space. The one-year lease term begins March 1.
The result of this asset exchange transaction is that it is recorded in two places: (1) Cato decreases assets (Cash) and (2) increases assets (Prepaid Rent).
Assets =
Liab. +
Stockholders' Equity
Cash
Prepaid Rent
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
(12,000)
12,000
n/a OA
Part I
Event 3: On March 1, Year 2, Cato signed a one-year lease agreement and paid $12,000 cash in advance to rent office space. The one-year lease term begins March 1.
Part II
This transaction decreases the Cash asset account, but increases another asset, Prepaid Rent. Therefore, it is classified as an asset exchange transaction. The Prepaid Rent is recorded as an asset, but will become an expense later when it is used. The income statement is not affected, but the statement of cash flows will report an outflow for operating activities.
Part III
Here is the effect of this transaction on the financial statements model.

28. Accounting for Prepaid Items
Exhibit 2.5: Relationship between Costs, Assets, and Expenses
Costs
Result in
Assets (deferred expense), like Prepaid Rent
When used result in
Expenses, like Rent Expense OR
Directly
Expenses, like Utilities Expense
As this diagram shows, the cost of the office space described in Event 3 is an asset. It is recorded in the asset account Prepaid Rent. Cato expects to benefit from incurring this cost by using the office to generate revenue over the next 12 months. Expense recognition is deferred until Cato actually uses the office space to help generate revenue. Other commonly deferred expenses include prepaid insurance and prepaid taxes. As these titles imply, deferred expenses are frequently called prepaid items.

29. Adjustment 2
Cato recognized rent expense for the office space used during the accounting period.
The result of this asset use transaction is that it is recorded in two places: (1) as a decrease in assets (Prepaid Rent) and (2) as a decrease in stockholders’ equity (Retained Earnings).
$12,000 Cost of annual lease ÷ 12 Months = $1,000 Cost per month
$1,000 Cost per month × 10 Months used = $10,000 Rent expense
Assets =
Liab. +
Stockholders' Equity
Cash
Prepaid Rent
Salaries Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
(10,000)
10,000
Part I
Year-End Adjustment 2: Cato recognized rent expense for the office space used during the accounting period.
Part II
Recall that Cato paid $12,000 on March 1, Year 2, to rent office space for one year (see Event 3). Between March 1st and December 31st, Cato has used 10 of the 12 months’ rent. Therefore, Cato must recognize $10,000 of rent expense, and reduce the prepaid rent asset. It is classified as an asset use transaction.
Part III
Here is the effect of this transaction on the financial statements model.

30. LO 2-7: Show how accounting for unearned revenues affects financial statements.
Learning Objective 2-7: Show how accounting for unearned revenues affects financial statements.

31. Second Accounting Cycle: Event 4
Cato received $18,000 cash in advance from Westberry Company for consulting services to be performed over a one- year period beginning June 1, Year 2.
The result of this asset source transaction is that it is recorded in two places: (1) as an increase in assets (Cash) and (2) as an increase in liabilities (Unearned Revenue).
Assets =
Liab. +
Stockholders' Equity
Cash
Prepaid Rent
Unearned Revenue
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
18,000
n/a OA
Part I
Event 4: Cato received $18,000 cash in advance from Westberry Company for consulting services Cato agreed to perform over a one-year period beginning June 1, Year 2.
Part II
This transaction increases the Cash asset account, and increases a liability account called Unearned Revenue. Cato must defer, or delay, any revenue until it performs the consulting services for Westberry Company, so the income statement is not affected. The deferred, or unearned, revenue is a liability for Cato because it is obligated to perform the services in the future. The statement of cash flows reports an inflow for operating activities. This is classified as an asset source transaction.
Part III
Here is the effect of this transaction on the financial statements model.

32. Adjustment 3
Cato recognizes the portion of the unearned revenue it earned during the accounting period.
The result of this claims exchange transaction is that it is recorded in two places: (1) as a decrease in liabilities (Unearned Revenue) and (2) an increase in stockholders’ equity (Retained Earnings).
$18,000 ÷ 12 months = $1,500 revenue earned per month
$1,500 × 7 months = $10,500 revenue to be recognized in Year 2
Assets =
Liab. +
Stockholders' Equity
Cash
Prepaid Rent
Unearned Revenue
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
(10,500)
10,500
Part I
Year-End Adjustment 3: Cato recognized the portion of the unearned revenue it earned during the accounting period.
Part II
Recall that Cato received an $18,000 cash advance from Westberry Company to provide consulting services from June 1, Year 2, to May 31, Year 3 (see Event 4). By December 31, Cato had earned 7 months (June 1 through December 31) of the revenue related to this contract. Rather than recording the revenue continuously as it performed the consulting services, Cato can simply recognize the amount earned in a single adjustment to the accounting records at the end of the accounting period. Cato can recognize revenue for 7/12 of the $18,000, or $10,500. Because a liability account decreases and an equity account increases, it is classified as a claims exchange transaction. Like all other year-end adjustments, it does not affect the statement of cash flows.
Part III
Here is the effect of this transaction on the financial statements model.

33. LO 2-8: Prepare financial statements that include deferrals.
Learning Objective 2-8: Prepare financial statements that include deferrals.

34. Other Year 2 Events
Event 5 provided $96,400 of consulting services on account.
Event 6 collected $105,000 cash from customers as partial settlement of accounts receivable.
Event 7 paid $32,000 for salary expense.
Event 8 incurred $21,000 of other operating expenses on account.
Event 9 paid $18,200 in partial settlement of accounts payable.
Part I
Event 5: During Year 2, Cato Consultants provided $96,400 of consulting services to its clients but no cash has been collected.
Part II
Event 6: The company collected $105,000 cash from customers as partial settlement of accounts receivable.
Part III
Event 7: Cato Consultants paid $32,000 for salary expense.
Part IV
Event 8: The company also incurred $21,000 of other operating expenses on account.
Part V
Event 9: And the company paid $18,200 in partial settlement of accounts payable.

35. Other Year 2 Events (Continued)
Event 10 paid $79,500 to purchase land it planned to use in the future as a building site for its home office.
Event 11 paid $21,000 in cash dividends to its stockholders.
Event 12 acquired $2,000 cash from issuing additional shares of common stock.
Adj. 4 recognized $4,000 of accrued salary expense.
Part I
Event 10: Cato Consultants paid $79,500 to purchase land it planned to use in the future as a building site for its home office.
Part II
Event 11: The company paid $21,000 in cash dividends to its stockholders.
Part III
Event 12: The company also acquired $2,000 cash from issuing additional shares of common stock.
Part IV
Year-End Adjustment 4: Cato Consultants recognized $4,000 of accrued salary expense.

36. Exhibit 2.7: Preparing Financial Statements
Here are Cato Consultants financial statements. At the top is the income statement followed by the statement of stockholders’ equity. Recall that revenue represents the benefit Cato experiences from operating its business. In accounting terms, revenue can be defined as increases in assets or decreases in liabilities from providing goods or services to customers in the normal course of operations. Expenses are the sacrifices that must be made to earn revenues. In accounting terms, expenses can be defined as decreases in assets or increases in liabilities resulting from consuming assets and services to generate revenue.
For each year, trace the amount of net income from the income statement to the statement of changes in stockholders’ equity.
The third financial statement is the balance sheet for Cato Consultants. It discloses the entity’s assets, liabilities, and stockholders’ equity at a particular point in time. At December 31, Year 2, Cato has $106,350 in assets. Assets are listed on the balance sheet in order of liquidity; that is, how rapidly they are expected to turn into cash. The lower half of the balance sheet describes the parties who have a claim or ownership interest in the company’s assets. Trace the ending balances of common stock and retained earnings reported on the statement of changes in stockholders’ equity to the stockholders’ equity section of the balance sheet.
At the bottom of the exhibit is Cato 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. Confirm that the amount of cash reported on the balance sheet equals the ending cash balance on the statement of cash flows.
Notice that the amount of cash flows from operations in Year 2 of $54,800 is different from the $39,250 in net income reported on the income statement we saw earlier. The difference results from the cash consequences associated with revenues and expenses as compared to the accrual reporting of revenues and expenses. Don’t fall in the trap of confusing revenue and expenses as equivalent with cash.

37. LO 2-10: Discuss the primary components of corporate governance.
Learning Objective 2-10: Discuss the primary components of corporate governance.

38. 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.
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. Following slides present key components of corporate governance.

39. 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.
The accountant’s role in society requires trust and credibility. Accounting information is worthless if the accountant is not trustworthy.

40. Exhibit 2.9: AICPA Code of Professional Conduct
Principles of Professional Conduct: AICPA Code of Professional Conduct
Responsibilities Principle: In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities.
The Public Interest Principle: Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.
Integrity principle: To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.
Objectivity and Independence Principle: A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.
Due Care Principle: A member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professionally responsibility to the best of the member’s ability.
Scope and Nature of Services Principle: A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.
This slide presents Exhibit 2.9, which summarizes the preface of the Code and includes six Principles of Professional Conduct.

41. The Fraud Triangle
The Fraud Triangle is a shape with three corners that represent the elements present when a fraud occurs, which are:
The availability of an opportunity;
Some form of pressure leading to an incentive to commit fraud; and
The capacity for rationalization that the fraud will “right some type of wrong.”
Unfortunately, it takes more than a code of conduct to stop fraud. People frequently engage in activities that they know are unethical or even criminal. The auditing profession has identified three elements that are typically present when fraud occurs, including:
The availability of an opportunity.
The existence of some form of pressure leading to an incentive.
The capacity to rationalize.
These three interrelated elements are frequently called the fraud triangle.

42. APPENDIX
APPENDIX

43. LO 2-11: Compute depreciation expense and show how it affects financial statements.
APPENDIX: Learning Objective 2-11: Compute depreciation expense and show how it affects financial statements.

44. Event 1: Purchase of Equipment
On January 1, Year 1, Libby paid $43,000 cash to purchase a forklift.
Libby expected to rent the forklift to its customers during the coming four years and then to sell the used forklift for $3,000. The expected period of use is commonly called the useful life. The amount Libby expects to receive from the sale of the asset at the end of its useful life is called the salvage value.
Assets =
Liab. +
Stockholders' Equity
Cash
Fork Lift
Unearned Revenue
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
(43,000)
43,000
n/a IA
Event 1: On January 1, Year 1, Libby paid $43,000 cash to purchase a forklift.
Libby expected to rent the forklift to its customers during the coming four years and then to sell the used forklift for $3,000. The expected period of use is commonly called the useful life. The amount Libby expects to receive from the sale of the asset at the end of its useful life is called the salvage value.
Analysis of the transaction shows the purchase of the forklift is an asset exchange transaction. The balance in the Cash account decreases and the balance in a new asset account called Forklift increases.

45. Event 2: Issuing a Promissory Note
On February 1, Year 1, Libby borrowed $5,000 cash from the State Bank.
As evidence of the debt, Libby issues a promissory note that describes the company’s obligations to the bank. The note stipulates a one-year term and an annual interest rate of 6 percent. Issuing the note is an asset source transaction. The asset account Cash increases and a new liability account called Notes Payable increases. The income statement is not affected.
Assets =
Liab. +
Stockholders' Equity
Cash
Prepaid Rent
Notes Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
5,000
n/a FA
Event 2: On February 1, Year 1, Libby borrowed $5,000 cash from the State Bank.
As evidence of the debt, Libby issues a promissory note that describes the company’s obligations to the bank. The note stipulates a one-year term and an annual interest rate of 6 percent. Issuing the note is an asset source transaction. The asset account Cash increases and a new liability account called Notes Payable increases. The income statement is not affected.

46. Event 3: Rent Revenue
During Year 1, Libby earned $16,000 cash by renting the forklift to its customers.
Assets =
Liab. +
Stockholders' Equity
Cash
Prepaid Rent
Notes Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
16,000
n/a OA
Event 3: During Year 1, Libby earned $16,000 cash by renting the forklift to its customers.

47. Event 4: Estimating Straight-Line Depreciation
On December 31, Year 1, Libby adjusts its accounts to recognize the expense of using the forklift during Year 1.
(Asset cost – Salvage Value) ÷ Useful Life = Depreciation Expense
($43,000 − $3,000) ÷ 4 years = $10,000/year Straight-line Depreciation
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.
Assets =
Liab. +
Stockholders' Equity
Cash
Accum.
Deprec.
Notes Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
(10,000)
10,000
To measure the net economic benefit of running a business, assume that Libby Company uses a forklift and must estimate how much of the cost of the forklift it used in the process of earning revenue. If the forklift has a four-year useful life and a $3,000 salvage value and cost $43,000 when purchased, it is logical to allocate an equal amount of the $40,000 to expense ($43,000 − $3,000) each year the equipment is used. This method of computing the depreciation expense evenly over the useful life is called straight-line depreciation.
Recognizing depreciation expense is an asset use transaction. Assets and equity decrease. On the income statement, expenses increase and net income decreases. There are no cash flow consequences. Recall that the cash outflow occurred at the time the asset was purchased. There is no cash flow when the expense is recognized. 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.

48. Book Value Forklift $43,000 Accumulated Depreciation (10,000)
(Also called Carrying Value)
$33,000
The contra asset account called Accumulated Depreciation is used because this approach preserves the original cost of the asset in the records and increases the usefulness of the information. The book value of the asset is the difference between the balances in the Forklift account and the related Accumulated Depreciation account as shown in this slide after the equipment’s first year of use. The book value may also be called the carrying value.
While Depreciation expense is a temporary account, the Accumulated Depreciation account is a permanent account that increases (or accumulates) each time depreciation expense is recognized.

49. LO 2-12: Compute interest expense and show how it affects financial statements.
APPENDIX: Learning Objective 2-12: Compute interest expense and show how it affects financial statements.

50. Event 6: Accrue Interest Payable
On December 31, Year 1, Libby adjusts its books to recognize the amount of interest expense incurred during Year 1. (This transaction is a Claims Exchange.)
Recall that Libby borrowed $5,000 on February 1, Year 1.
As a result, Libby owes the bank interest for the 11 months the loan was outstanding during the year. The accrued interest is $275 ($5,000 × .06 × 11/12).
Assets =
Liab. +
Stockholders' Equity
Cash
Fork Lift
Interest Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a
275
(275)
Event 6: On December 31, Year 1, Libby adjusts its books to recognize the amount of interest expense incurred during Year 1.
Recall that Libby borrowed $5,000 on February 1, Year 1.
As a result, Libby owes the bank interest for the 11 months the loan was outstanding during the year.
The accrued interest is $275 ($5,000 × .06 × 11/12). The adjusting entry changes the ratio of the company’s responsibilities to creditors and investors. It is therefore called a claims exchange event.
The adjusting entry is a claims exchange event. The liability account Interest Payable increases, and the equity account Retained Earnings decreases.
The income statement would report interest expense. However, there is no effect on cash flow because the actual cash payment for interest will be made on the maturity date in Year 2.

51. Exhibit 2.11: Summarized Events for Libby in Year 1
Assets =
Liab. +
Equity
Cash
Fork Lift
Notes
Payable
Interest Payable
Ret. Earn.
Other Account Titles
Event
Beginning Balance
$43,000
$ 0 
$ 0 $0
1. Purchase fork lift
(43,000)
43,000
2. Borrowed Cash
5,000
3. Recognize Revenue
16,000
Revenue
4. Recognize depreciation
(10,000) 
(10,000)
Depreciation Expense
5. Accrued Interest
275
(275)
Interest Expense
Ending Balance
$ 21,000
$33,000
$ 5,000
$ 275
$ 48,725
The events experienced by Libby during Year 1 are summarized in Exhibit 2.11.

52. Accounting Events for Year 2
1. Recognize Interest Expense
Assets =
Liab. +
Stockholders' Equity
Cash
Fork Lift
Interest Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
n/a 25
(25)
2. Cash Payment for Interest Payable
Assets =
Liab. +
Stockholders' Equity
Cash
Fork Lift
Interest Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
(300)
n/a OA
3. Repaying the Principal
Assets =
Liab. +
Stockholders' Equity
Cash
Fork Lift
Note Payable
Common Stock
Retained Earnings
Revenue −
Expenses
Net Income
Cash Flow
(5,000)
n/a FA
Three entries for Year 2:
Libby would record three journal entries on January 31, Year 2 (the maturity date). The first entry recognizes $25 ($5,000 × .06 × 1/12) of interest expense that accrued in Year 2 for the month of January.
The second entry records Libby’s cash payment for interest payable. This entry is an asset use transaction that reduces both the Cash and Interest Payable accounts for the total amount of interest due, $300. The interest payment includes the 11 months interest accrued in Year 1 and one month accrued in Year 2 ($275 + $25 = $300).
The third entry on January 31, Year 2, reflects repaying the principal. This entry is an asset use transaction. The Cash account and the Notes Payable account each decrease by $5,000.

53. Libby’s Financial Statements for Years 1 & 2
Libby’s balance sheets, income statements, and statements of cash flows for Year 1 and Year 2 are shown in Exhibit The statements assume revenue for Year 2 is also $16,000 cash and the company made the appropriate adjusting entry to recognize depreciation expense.

54. End of Chapter 2
End of Chapter 2. In this chapter, we learned more about the accrual basis of accounting and the accounting cycle. We also learned about corporate governance and the fundamentals of ethical accounting practices.