Chapter 2
Accounting for
Accruals and
Deferrals
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved
Cash Basis vs.
Accrual Accounting
Recognition
Realization
Formally recording
an economic
item or event in the
financial statements
Collecting cash,
generally from the
sale of products or
services
2-1
SECTION 1: SHOW HOW ACCRUALS
AFFECT FINANCIAL STATEMENTS
LO 1:
Show how
receivables
affect financial
statements.
2-2
Event 1: Cato Consultants was started on January 1,
2013, when it acquired $5,000 cash by issuing
common stock.
1. Increase assets (Cash).
2. Increase stockholders’
equity (Common Stock).
Assets
Cash
5,000
+
+
=
Supplies
n/a
=
=
Liab.
+
n/a
+
+
Stockholders' Equity
Common
Retained
Stock
+ Earnings
5,000 +
n/a
Asset Source
Transaction
Revenue - Expenses
n/a
n/a
=
=
Net
Income
n/a
Cash Flow
5,000 FA
2-3
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).
Assets
= Liab. +
Stockholders' Equity
Accounts
Salaries
Common
Retained
Cash + Receivable = Payable + Stock + Earnings
+
+
+
n/a
84,000 =
n/a
n/a
84,000
Asset Source
Transaction
Revenue
- Expenses = Net Income
84,000 n/a
=
84,000
Cash Flow
n/a
2-4
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).
Assets
= Liab. +
Stockholders' Equity
Accounts
Salaries
Common
Retained
Cash + Receivable = Payable + Stock + Earnings
+
+
60,000 +
(60,000) =
n/a
n/a
n/a
Asset
Exchange
Transaction
Revenue - Expenses =
n/a
n/a
=
Net
Income
n/a
Cash Flow
60,000 OA
2-5
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).
Assets
=
Accounts
Cash
+ Receivable =
=
(10,000) +
n/a
Liab.
n/a
Stockholders' Equity
Common
Retained
+ Stock + Earnings
+ n/a
+
(10,000)
Asset Use
Transaction
+
Revenue - Expenses =
n/a
10,000 =
Net Income
(10,000)
Cash Flow
(10,000) OA
2-6
Event 5: Cato paid $2,000 for advertising
costs. The advertisements appeared in 2013.
1. Decrease assets (cash).
2. Decrease stockholders’
equity (retained
earnings).
Assets
=
Accounts
Cash
+ Receivable =
=
(2,000) +
n/a
Liab.
n/a
Stockholders' Equity
Common
Retained
+ Stock + Earnings
+ n/a
+
(2,000)
Asset Use
Transaction
+
Revenue - Expenses =
n/a
2,000 =
Net Income
(2,000)
Cash Flow
(2,000) OA
2-7
Event 6: Cato signed contracts for $42,000 of
consulting services to be performed in 2014.
Not recognized
in the 2013
financial
statements
Assets
Cash
n/a
+
+
=
Prepaid
Rent
n/a
=
=
Liab.
+
n/a
+
+
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
n/a
Revenue
n/a
- Expenses
n/a
=
=
Net Income
n/a
Cash Flow
n/a
2-8
SECTION 1: SHOW HOW ACCRUALS
AFFECT FINANCIAL STATEMENTS
LO 2
Show how
payables affect
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).
Claims
Exchange
Transaction
2. Decrease stockholders’
equity (retained
earnings).
Assets
=
Cash
n/a
=
=
Liab.
Salaries
Payable
6,000
+
+
+
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
(6,000)
Revenue
n/a
-
Expenses
6,000
=
=
Net Income
(6,000)
Cash Flow
n/a
2-10
Vertical
Statements
Model
2- 11
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 and Permanent
Accounts
Assets
Temporary accounts
track financial
results for a limited
period of time.
Liabilities
Permanent
Accounts
Equity
Temporary
Accounts
Dividends
Expenses
Revenues
Permanent accounts
track financial
results from year to
year.
2-14
Steps in an Accounting Cycle
Record
Transactions
Close Nominal
Accounts
Adjust
Accounts
Prepare
Statements
2-15
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.
2-16
The Conservatism Principle
When faced with a recognition
dilemma, conservatism guides
accountants to select the
alternative that produces the
lowest amount of net income.
2-17
Event 1: Cato paid $6,000 to the instructor to
settle the salaries payable obligation.
1. Decrease cash (assets).
2. Decrease liabilities
(salaries payable).
Assets
=
Accounts
Cash
+ Receivable =
=
(6,000) +
n/a
Liab.
+
Stockholders' Equity
Salaries
Common
Retained
Payable + Stock + Earnings
+
(6,000) + n/a
n/a
Asset Use
Transaction
Revenue - Expenses
n/a
n/a
=
=
Net Income
n/a
Cash Flow
(6,000) OA
2-18
SECTION 2: SHOW HOW DEFERRALS
AFFECT FINANCIAL STATEMENTS
LO 3
Show how
supplies affect
financial
statements.
2-19
Event 2: Cato purchased $800 of supplies on
account.
1. Increase assets
(supplies).
Asset Source
Transaction
2. Increase liabilities
(accounts payable).
Assets
Cash
n/a
+
+
=
Supplies
800
=
=
Liab.
+
Accounts
Payable +
800 +
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
n/a
Revenue
n/a
- Expenses
n/a
=
=
Net Income
n/a
Cash Flow
n/a
2-20
SECTION 2: SHOW HOW DEFERRALS
AFFECT FINANCIAL STATEMENTS
LO 4
Show how
prepaid items
affect
financial
statements.
2-21
Event 3: On March 1, 2014, 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.
1. Decrease assets (cash).
Asset
Exchange
Transaction
2. Increase assets (prepaid
rent).
Assets
Cash
+
(12,000) +
=
Prepaid
Rent
12,000
=
=
Liab.
+
n/a
+
+
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
n/a
Revenue
n/a
- Expenses
n/a
=
=
Net Income
n/a
Cash Flow
(12,000) OA
2-22
SECTION 2: SHOW HOW DEFERRALS
AFFECT FINANCIAL STATEMENTS
LO 5
Show how
unearned
revenues
affect financial
statements.
2-23
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, 2014.
1. Increase assets (cash).
Asset Source
Transaction
2. Increase liabilities
(unearned revenue).
Assets
Cash
18,000
=
Liab.
+
=
=
Unearned
Revenue
18,000
+
+
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
n/a
Revenue
n/a
-
Expenses
n/a
=
=
Net Income
n/a
Cash Flow
18,000 OA
2-24
Event 5: Cato provided $96,400 of consulting
services on account.
1. Increase assets (accounts
receivable).
2. Increase stockholders’
equity (retained earnings).
Assets
= Liab. +
Stockholders' Equity
Accounts
Salaries
Common
Retained
Cash + Receivable = Payable + Stock + Earnings
+
+
+
n/a
96,400 =
n/a
n/a
96,400
Asset Source
Transaction
Revenue
- Expenses = Net Income
96,400 n/a
=
96,400
Cash Flow
n/a
2-25
Event 6: Cato collected $105,000 cash from customers
in partial settlement of its accounts receivable.
1. Increase assets (cash).
2. Decrease assets
(accounts receivable).
Assets
= Liab. +
Stockholders' Equity
Accounts
Salaries
Common
Retained
Cash + Receivable = Payable + Stock + Earnings
+
+
105,000 + (105,000) =
n/a
n/a
n/a
Asset
Exchange
Transaction
Revenue - Expenses =
n/a
n/a
=
Net
Income
n/a
Cash Flow
105,000 OA
2-26
Event 7: Cato paid $32,000 cash for salary expense.
1. Decrease cash (assets).
2. Decrease stockholders’
equity (retained
earnings).
Assets
=
Accounts
Cash
+ Receivable =
=
(32,000) +
n/a
Liab.
n/a
Stockholders' Equity
Common
Retained
+ Stock + Earnings
+
+
n/a
(32,000)
Asset Use
Transaction
+
Revenue - Expenses
=
n/a
32,000 =
Net Income
(32,000)
Cash Flow
(32,000) OA
2-27
Event 8: Cato incurred $21,000 of other
operating expenses on account.
1. Increase liabilities
(accounts payable).
2. Decrease stockholders’
equity (retained
earnings).
Assets
n/a
=
=
=
Liab.
+
Claims
Exchange
Transaction
Stockholders' Equity
Accounts
Common
Payable + Stock +
+
21,000 +
n/a
Retained
Earnings
(21,000)
Revenue - Expenses =
n/a
21,000 =
Net Income
(21,000)
Cash Flow
n/a
2-28
Event 9: Cato paid $18,200 cash in partial
settlement of accounts payable.
1. Decrease assets (cash).
2. Decrease liabilities
(accounts payable).
Assets
=
Cash
=
(18,200) =
Liab.
+
Accounts
Payable
+
(18,200) +
Asset Use
Transaction
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
n/a
Revenue
n/a
- Expenses
n/a
=
=
Net Income
n/a
Cash Flow
(18,200) OA
2-29
Event 10: Cato paid $79,500 for land it planned to use in
the future as a building site for its home office.
1. Decrease assets (cash).
Asset
Exchange
Transaction
2. Increase assets (land).
Assets
Cash
+
(79,500) +
=
Land
79,500
=
=
Liab.
+
n/a
+
+
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
n/a
Revenue
n/a
- Expenses
n/a
=
=
Net Income
n/a
Cash Flow
(79,500) IA
2-30
Event 11: Cato paid $21,000 in cash dividends
to its stockholders.
1. Decrease assets (cash).
2. Decrease stockholders’
equity (retained
earnings).
Assets
=
Cash
=
(21,000) =
Liab.
+
n/a
+
+
Asset Use
Transaction
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
(21,000)
Revenue
n/a
-
Expenses
n/a
=
=
Net Income
n/a
Cash Flow
(21,000) FA
2-31
Event 12: Cato acquired $2,000 cash from issuing
additional shares of common stock.
1. Increase assets (Cash).
2. Increase stockholders’
equity (Common Stock).
Assets
Cash
2,000
+
+
=
Supplies
n/a
=
=
Liab.
+
n/a
+
+
Stockholders' Equity
Common
Retained
Stock
+ Earnings
2,000 +
n/a
Asset Source
Transaction
Revenue - Expenses
n/a
n/a
=
=
Net
Income
n/a
Cash Flow
2,000 FA
2-32
SECTION 2: SHOW HOW DEFERRALS
AFFECT FINANCIAL STATEMENTS
LO 6
Explain the
accounting cycle
including
adjustments and
the closing
process.
2-33
Event 13: After determining through a physical count that
it had $150 of unused supplies on hand as of December
31, Cato recognized supplies expense.
1. Decrease assets
(supplies).
Asset Use
Transaction
2. Decrease stockholders’
equity (retained
earnings).
Beginning
supplies
balance
$0
Assets
=
Supplies
=
(650) =
+
Supplies
purchased
$800
Liab.
n/a
+
+
+
Supplies
available for
=
use
$800
Ending
supplies
balance
$150
=
Supplies
used
$650
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
(650)
Revenue
n/a
- Expenses
=
650 =
Net Income
(650)
Cash Flow
n/a
2-34
Event 14: Cato recognized rent expense for the
office space used during the accounting period.
1. Decrease assets (prepaid
rent).
Asset Use
Transaction
2. Decrease stockholders’
equity (retained
earnings).
Assets
=
Prepaid rent =
(10,000) =
Liab.
+
n/a
+
+
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
(10,000)
Revenue
n/a
- Expenses
=
10,000 =
Net Income
(10,000)
Cash Flow
n/a
2-35
Event 15: Cato recognized the portion of the unearned
revenue it earned during the accounting period.
1. Decrease liabilities
(unearned revenue).
2. Increase stockholders’
equity (retained
earnings).
Assets
=
n/a
=
=
Liab.
+
Unearned
Revenue
+
(10,500) +
Claims
Exchange
Transaction
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
10,500
Revenue
- Expenses
10,500 n/a
=
=
Net Income
10,500
Cash Flow
n/a
2-36
Event 16: Cato recognized $4,000 of accrued salary
expense.
1. Increase liabilities
(salaries payable).
Claims
Exchange
Transaction
2. Decrease stockholders’
equity (retained
earnings).
Assets
=
n/a
=
=
Liab.
Salaries
Payable
4,000
+
+
+
Stockholders' Equity
Common
Stock
n/a
+
+
Retained
Earnings
(4,000)
Revenue
n/a
- Expenses
=
4,000 =
Net Income
(4,000)
Cash Flow
n/a
2-37
SECTION 2: SHOW HOW DEFERRALS
AFFECT FINANCIAL STATEMENTS
LO 7
Prepare
financial
statements
based
on accrual
accounting.
2-38
Preparing Financial Statements
2-39
Preparing Financial Statements
2-40
Preparing Financial Statements
2-41
SECTION 2: SHOW HOW DEFERRALS
AFFECT FINANCIAL STATEMENTS
LO 8
Classify accounting
events into one
of four categories:
■ Asset source
■ Asset use
■ Asset exchange
■ Claims exchange
2-42
Recap: Types of Transactions
The described transactions can be
classified into one of four categories:
Asset
source
Asset
use
Asset
Claims
exchange exchange
Increase
assets,
increase
claims on
assets
Decrease
assets,
decrease
claims on
assets
Increase one Increase one
asset, claims account,
decrease
decrease
another
another.
asset
2-43
SECTION 2: SHOW HOW DEFERRALS
AFFECT FINANCIAL STATEMENTS
LO 9
Discuss the
primary
components
of corporate
governance.
2-44
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.
2-45
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.
2-46
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.
2-47
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
2-48
The Fraud Triangle
Opportunity
Key to protecting
yourself and your
company: personal
integrity.
Pressure
Rationalization
2-49
APPENDIX
LO 11
Compute
interest
expense and
show how it
affects financial
statements.
2-50
Calculating Interest
1. Increase liabilities
(Interest Payable).
2. Decrease stockholders’
equity (Retained Earnings).
Assets
Cash
n/a
+
+
=
Equipment
n/a
=
=
Liab.
+
Interest
Payable
+
$
275 +
Stockholders' Equity
Common
Retained
Stock
+
Earnings
+ $
(275)
Claims
Exchange Event
Revenue - Expenses
=
n/a
275 =
Net Income
(275)
Cash Flow
n/a
2-51
End of Chapter Two
2-52