Chapter Two

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Chapter Two

• Accounting for Accruals

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Accrual Accounting
Virtually all of the major companies operating in
the United States use accrual accounting.
Lets demonstrate accrual accounting by
describing seven events that relate to a company
named Conner Consultants.
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Event 1 Conner Consultants was started on
January 1, 2004, when it acquired 5,000 cash by
issuing common stock.
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Event 2 During 2004, Conner Consultants
provided 84,000 of consulting services to its
clients but no cash has been collected.
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Event 3 Conner collected 60,000 cash from
customers in partial settlement of its accounts
receivable.
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Event 4 The instructor earned a salary of
16,000. No cash has yet been paid to the
employee.
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Event 5 Conner paid 10,000 to the instructor
in partial settlement of salaries payable.
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Event 6 Conner paid 2,000 for advertising
costs. The advertisements appeared in 2004.
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Event 7 Conner signed contracts for 42,000 of
consulting services to be performed in 2005.
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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, lets prepare the financial statements for
Conner Consulting using the data presented above.
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Preparing Financial Statements
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Preparing Financial Statements
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Preparing Financial Statements
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The Closing Process
Transfers net income (or loss) and dividends to
Retained Earnings.
Establishes zero balances in all revenue,
expense, and dividend accounts.
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Temporary and Permanent Accounts
Temporary accounts track financial results for a
limited period of time.
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General Ledger Accounts
Here are the general ledger accounts for Conner
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
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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.
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Second Accounting Cycle
Assume the following events apply to Conner
Consultants during 2005.
Since you are familiar with these types of
events, lets look at the summary of the general
ledger accounts for Conner Consultants.
Now, lets move on to events 7 8.
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Event 7 On March 1, 2005, Conner invested
60,000 in a certificate of deposit (CD).
Investing Activity
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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.
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Adjusting Entries
Update account balances
Prior to preparing financial statements
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Summary of General Ledger Accounts
Here is a summary of the general ledger accounts
for Conner Consulting at December 31, 2005.
Now, lets prepare the 2005 financial statements
for Conner Consulting using the data presented
above.
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Preparing Financial Statements
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Preparing Financial Statements
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Preparing Financial Statements
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Steps in an Accounting Cycle
Record Transactions
Now, lets look at some more transactions for
Conner Consultants.
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On September 1, 2006, Conner borrowed 90,000
cash from First City Bank by issuing a 1 year
note at 9 interest.
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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.
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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.
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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.
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Vertical Financial Statements
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Vertical Financial Statements
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Vertical Financial Statements
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The Financial Analyst
How can a financial analyst know that a company
really did follow GAAP?
Audits
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Materiality and Financial Audits
Auditors do not guarantee that financial
statements are absolutely correctonly that they
are materially correct.
Material Item An error, or other reporting
problem, that would influence the decision of an
average prudent investor.
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Types of Audit Opinions
Unqualified
Adverse
Qualified
Disclaimer
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Importance of Ethics
Code of Conduct
Sarbanes-Oxley Act of 2002
Internal Controls
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End of Chapter Two