Chapter 2 Lecture Notes PDF

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Chapter 2 – Accounting for Accruals and Deferrals Professional Headhunters, Inc. (PHI), a job placement company, operates in the northeastern United States. During 2019, the company earned $145,000 in revenue by providing services to customers. However, it collected only $120,000 of the revenue in cash. PHI expected to collect the remaining $25,000 in 2020. In addition, PHI incurred $80,000 of expenses. However, by the end of 2019, PHI had paid only $75,000 of the cash owed for expenses because it had not yet paid $5,000 to employees who had worked during 2019 but had not been paid by the end of the year. PHI expected to pay the $5,000 in cash to the employees during 2020. Based on this information alone, determine the amount of net income PHI should report on its 2019 financial statements. You will see in this chapter that while the exchange of cash will effect balance sheet elements (assets, liabilities, revenue, expenses, etc.) of the financial statements, when calculating net income only amounts earned (whether or not the company has collected the cash) can be considered revenue and only expenses that have occurred (whether or not the company has paid cash for them) can be recorded as expenses. Accrual Accounting vs. Cash Basis Accounting:  The exchange of cash can occur before or after a transaction is recorded that may affect revenues and expenses.  Under the rules of accrual accounting (required by GAAP): o Revenues are recorded when they’re earned regardless of when the cash is collected.  Revenue occurs when another party has received a benefit from your company. o Expenses are recorded when they’re incurred (they occur).  Expenses occur when your company has received a benefit.  Under cash basis accounting, the exchange of cash occurs at the same time as the revenue or expense is recorded. o Not used by any publicly traded companies. Account Name

What does the balance represent?

Accounts receivable

Amount owed from customers for goods or services already provided Amount paid in advance of occupancy of space (prepaid rent) or insurance coverage (prepaid insurance) Amount received in advance from customers for goods or services to be provided later Amount due to vendors Amount due to employees for services provided

Prepaid rent or prepaid insurance Unearned revenue

Accounts payable Salaries payable

What type of account? Asset

Normal balance? Debit

Asset

Debit

Liability

Credit

Liability Liability

Credit Credit

Accounting for Accruals:  The term accrual describes a revenue or an expense event that is recognized before cash is exchanged. Examples of accruals: o Assets – Accounts Receivable – Amount owed from customers for goods or services already provided o Liabilities – Salaries Payable – Amount due to employees for services provided

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Practice Problem #1 CATO CONSULTANTS 2019 TRANSACTIONS: EVENT 1 - Cato Consultants was started on January 1, 2019, when it acquired $5,000 cash by issuing common stock. EVENT 2 - During 2019, Cato Consultants provided $84,000 of consulting services to its clients. The business has completed the work and sent bills to the clients, but not yet collected any cash. This type of transaction is frequently described as providing services on account. EVENT 3 - Cato collected $60,000 cash from customers in partial settlement of its accounts receivable. EVENT 4 - Cato paid the instructor $10,000 cash for teaching training courses (salary expense). EVENT 5 - Cato paid $2,000 cash for advertising costs. The advertisements appeared in 2019. EVENT 6 - Cato signed contracts for $42,000 of consulting services to be performed in 2020. EVENT 7 - ADJ 1 - At the end of 2019, Cato recorded accrued salary expense of $6,000 (the salary expense is for courses the instructor taught in 2019 that Cato will pay cash for in 2020). Required: 1. 2. 3. 4.

Record all transactions and any necessary adjustments on page 3. Prepare the company’s income statement and statement of changes in equity for 2019. Prepare the company’s balance sheet at 12/31/19. Calculate the net cash flows from operating, investing, and financing activities for 2019.

Regarding Adjustments – an entry required to update an account balance is called an adjusting entry.  Adjustments ______________ effect the cash account. o Adjustments occur because the cash exchange happened at a different time then when the revenue was earned or the expense was incurred so the cash account was either already effected or will be effected at a point in the future. o Expenses that are recognized before cash is paid are called accrued expenses. Adjustments ______________ effect stockholders’ equity. o The reason for making adjustments is to ensure that for the year the financial statements are being prepared for includes all revenues earned and expenses incurred Either recording an expense that has occurred (causing equity to ______) or recording revenue earned (causing equity to ______). 

Accounting Cycle:

2

ASSETS

Event #

CF

Cash

Accounts Receivable

Prepaid Rent

LIABILITIES

Land

=

Account s Payable

Salaries Payable

1 2 3 4 5 6 7 (ADJ 1) End Bal

Cash Flow totals: Operating = Financing = Investing =

3

EQUITY Unearne d Revenue

+

Common Stock

Retained Earnings

Account

4

Accounting for Deferrals:  In contrast to accruals, deferrals occur when cash changes hands first, and revenue or expense is recognized later.  Examples of deferrals: o Assets:  Prepaid expenses (rent, insurance)  Supplies (recorded as an asset when purchased, expensed when used)  Long-term assets such as equipment (recorded as an asset when purchased, expensed as depreciation) o Liabilities:  Unearned revenue (cash advances, retainers) Practice Problem #1 Continued CATO CONSULTANTS 2020 TRANSACTIONS: EVENT 1 - Cato paid $6,000 to the instructor to settle the salaries payable obligation. EVENT 2 - Cato purchased $800 of supplies on account. EVENT 3 - On March 1, 2020, Cato signed a one-year lease agreement and paid $12,000 cash in advance to rent office space. The one-year lease term began on March 1. 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, 2020. EVENT 5 - Cato provided $96,400 of consulting services on account. EVENT 6 - Cato collected $105,000 cash from customers as partial settlement of accounts receivable. EVENT 7 - Cato paid $32,000 cash for salary expense. EVENT 8 - Cato incurred $21,000 of other operating expenses on account. EVENT 9 - Cato paid $18,200 in partial settlement of accounts payable. EVENT 10 - Cato paid $79,500 to purchase land it planned to use in the future as a building site for its home office. EVENT 11 - Cato paid $21,000 in cash dividends to its stockholders. EVENT 12 - Cato acquired $2,000 cash from issuing additional shares of common stock. Required: 1. Record all transactions and any necessary adjustments. 2. Prepare the company’s income statement and statement of changes in equity for 2020. 3. Prepare the company’s balance sheet at 12/31/20. 4. Calculate the net cash flows from operating, investing, and financing activities for 2020.

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2020 Even t#

C F

Beg Bal 1

O

Cash

Accounts Receivable

53000

24000

Supplies

Prepaid Rent

0

0

Land

Account s Payable

Salaries Payable

Unearne d Revenue

0

0

6000

0

=

(6000) 800

O

(12000)

4

O

18000

5 O

105000

7

O

(32000)

5000

66000

12000 18000

O

(18200)

10

I

(79500)

11

F

(21000)

12

F

2000

96400

Service revenue

(32000)

Salary expense

(21000)

Operating Expenses

(21000)

Dividends

(650)

Supplies Expense

(10000)

Rent Expense

(105000)

21000

9

Account

800

8

(18200) 79500

2000 (650)

Adj 2

(10000)

Adj 3 Adj 4 End Bal

Retained Earnings

96400

6

Adj 1

Common Stock

(6000)

2 3

+

150

2000

6

7

Cash Flow totals: Operating = Financing = Investing = Practice Problem #1 Adjustments ADJ 1 (Supplies adjustment) - After determining through a physical count that it had $150 of unused supplies on hand as of December 31, Cato recognized supplies expense. Beginning supplies balance Plus: Supplies purchased Less: Supplies remaining = Supplies expense

$0 $ 800 $ (150) $ 650

1. How does the fact that some of the supplies purchased are still available at year-end effect the company’s income statement? Increased expenses by 650, decrease the Net Income 2. How does the fact that some of the supplies purchased are still available at year-end effect the company’s balance sheet? Decrase asset account supplies by 650, 150 that is left for 2021 BB, Net Income decrease

ADJ 2 (Rent adjustment) - Cato recognized rent expense for the office space used during the accounting period. Amount prepaid Divided by: # of months = Expense per month Multiplied by # of months occupied = Rent expense

$ 12,000 / 12 months = $1,000 X 10 months = $ 10,000

1. How does the fact that not all 12 months of the lease occurred in the same year effect the company’s income statement?

2. How does the fact that not all 12 months of the lease occurred in the same year effect the company’s balance sheet?

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ADJ 3 (Unearned revenue adjustment) - Cato recognized the portion of the unearned revenue it earned during the accounting period. Amount Collected Divided by: # of months Earnings per month Multiplied by # of months provided = Revenue earned that year

$ 18,000 / 12 months $ 1,500 X 7 months = $ 10,500

1. How does the fact that not all 12 months of the agreement occurred in the same year effect the company’s income statement?

2. How does the fact that not all 12 months of the agreement occurred in the same year effect the company’s balance sheet?

ADJ 4 (Accrued salary adjustment) - Cato recognized $4,000 of accrued salary expense (the salary expense is for courses the instructor taught in 2020 that Cato will pay cash for in 2021). 1. How does the fact that the expense has been incurred but not paid effect the company’s income statement?

2. How does the fact that the expense has been incurred but not paid effect the company’s balance sheet?

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Cato Consultants Income Statement For the Years ended 12/31/2019

12/31/2020

Service Revenue Salaries expense Advertising expense Rent expense Supplies expense Operating expense Net Income Cato Consultants Statement of Changes in Equity For the Years ended 12/31/2019

12/31/2020

Common Stock, Beginning Common Stock Issued Common Stock, Ending Retained Earnings, Beginning Net Income Less: Dividends Ending retained earnings Total Equity

10

Cato Consultants Balance Sheet At: 12/31/2019

12/31/2020

Assets Cash Accounts Receivable Prepaid Rent Supplies Land Total Assets Liabilities Salaries Payable Accounts Payable Unearned Revenue Total Liabilities Stockholders' Equity Common Stock Retained Earnings Total Equity Total Liabilities & Equity Matching Concept:   

Cash basis accounting can distort reported net income because it sometimes fails to match expenses with the revenues they produced. The objective of accrual accounting is to improve the matching of revenues with expenses. Example: The 2019 ADJ entry #1 - The $6,000 of accrued salary expense that Cato Consultants recognized at the end of year 1. o The instructor’s teaching produced revenue in year 1. If we wouldn’t had made the adjustment to recognize the $6,000 salary expense, then the expense would not have been matched with the revenue it generated.

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Practice Problem #2 The Sanders Company had the following balances at 12/31/2018: Cash $35,000 Accounts Receivable $9,000 Land $51,000

Accounts Payable Common Stock Retained Earnings

$7,500 $40,000 $47,500

The following events occurred in 2019. Jan 1 Feb 28 Mar 1 Apr 1 May 1 July 31

Acquired $20,000 cash from the issue of common stock Paid $15,000 cash in advance for a one-year lease of office space. The lease begins on March 1st. Paid a $2,000 cash dividend to stockholders Purchased additional land for $15,000 cash Made a cash payment on accounts payable of 5,500 Received $10,200 cash in advance for one year of services to be performed monthly beginning August 1st Earned $58,000 of service revenue on account during the year Received cash collections from accounts receivable amounting to $46,000 Incurred other operating expenses on account during the year that amounted to $28,000 Accrued $6,500 of salary expense

Dec 31 Dec 31 Dec 31 Dec 31 Required: 1. 2. 3. 4.

Record all transactions and any necessary adjustments. Prepare the company’s income statement and statement of changes in equity for 2019. Prepare the company’s balance sheet at 12/31/19. Calculate the net cash flows from operating, investing, and financing activities for 2019.

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13

2019

Event #

Beg Bal

ASSETS

CF

Cash

35,000

Accts Rec'v

9,000

Prepaid Rent

LIABILITIES

Land

=

Accts Pay

Sal. Pay

51,000

7,500

1-Jan 28-Feb 1-Mar 1-Apr 1-May 31-Jul 31-Dec 31-Dec 31-Dec 31-Dec Adj 1 Adj 2

End Bal

14

EQUITY Unearned Rev

+

Common Stock

40,000

Retained Earnings

47,500

Account

15

Cash Flow Totals Operating = Financing = Investing = Make sure that the sum of these 3 cash flow sections equal the change in cash

Total = Sanders Company Income Statement For the Year ended 12/31/2019 Service Revenue Salaries expense Operating expense Rent expense Net Income Sanders Company Statement of Changes in Equity For the Year ended 12/31/2019 Common Stock, Beginning Common Stock Issued Common Stock, Ending Retained Earnings, Beginning Net Income Less: Dividends Ending Retained Earnings Total Equity

Sanders Company

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Balance Sheet At 12/31/2019 Assets Cash Accounts Receivable Prepaid Rent Land Total Assets Liabilities Salaries Payable Accounts Payable Unearned Revenue Total Liabilities Stockholders' Equity Common Stock Retained Earnings Total Equity Total Liabilities & Equity

Practice Problem #3 Dupont Company had the following balances in its accounting records as of December 31, 2018: Assets: Cash Accounts Receivable Land Total Assets:

$35,000 9,000 51,000 $95,000

Claims: Accounts Payable Common Stock Retained Earnings Total Liabilities & Equity:

$7,500 40,000 47,500 $95,000

Record the following events for the year 2019: Jan 1 Acquired $10,000 cash from the issue of common stock Feb 1 a. Provided $38,000 of services on account b. Paid $18,000 for a one-year lease of office space which begins immediately Mar 1 Paid a $2,000 dividend to the stockholders April 1 Collected $29,000 cash due from accounts receivable July 1 Paid $4,600 cash for salary expense Sept 1 Received $7,200 cash in advance for services to be performed over the next 12-months Oct 1 Incurred $1,500 of other operating expenses on account Dec 1 Paid $6,200 cash due on the accounts payable Dec 31 Accrued $5,000 in salary expense 1. Record all transactions and necessary adjustments in the horizontal model. 17

2019

Event # Beg Bal

ASSETS

CF

Cash

35,000

Accts Rec'v

9,000

Prepaid Rent

LIABILITIES

Land

51,000

=

Accounts Payable

Salary Payable

EQUITY

Unearned Rev

+

Common Stock

40,000

7,500

1-Jan 1-Feb 1-Feb 1-Mar 1-Apr 1-Jul 1-Sep 1-Oct 31Dec 31Dec Adj 1 Adj 2 End Bal

18

Retained Earnings

47,500

Account

19

2. Create an income statement, statement of changes in equity, and balance sheet for 2019. 3. Compute the net cash flows from operating, investing, and financing for 2019.

Cash Flow Totals Operating = Financing = Investing = Make sure that the sum of these 3 cash flow sections equal the change in cash

Total =

Dupont Compnay Income Statement For the Year ended 12/31/2019 Service Revenue Salaries expense Operating expense Rent expense Net Income Dupont Company Statement of Changes in Equity For the Year ended 12/31/2019 Common Stock, Beginning Common Stock Issued Common Stock, Ending Retained Earnings, Beginning Net Income Less: Dividends Ending Retained Earnings Total Equity

20

Dupont Company Balance Sheet At 12/31/2019 Assets Cash Accounts Receivable Prepaid Rent Land Total Assets Liabilities Accounts Payable Salary Payable Unearned Revenue Total Liabilities Stockholders' Equity Common Stock Retained Earnings Total Equity Total Liabilities & Equity

21

Practice Problem #4 What effect do the following transactions have on net income and cash flows? Event

Effect on Net Income

Effect on Cash Flows

Cash sales made during the last week of the year aren’t recorded

Net income would be understated (too low) because revenue wasn’t recorded

Cash flows from operating activities (therefore total cash flows) would be understated (too low) because the cash received wasn’t recorded

A company neglects to record the expired portion of insurance they paid in advance earlier in the year Services provided on account during the last week of the year aren’t recorded A landlord receives cash on July 1st for a 6 month lease and records this as unearned revenue. The landlord fails to make an adjustment at the end of the year Supplies are counted at the end of the year but no adjustment is made to reflect the difference between the amount of supplies on hand earlier in the year versus the end of the year Work for a client is begun in November but won’t be completed and billed until the end of January so nothing has been recorded.

22

Effect on Balance Sheet Assets and equity would be understated (too low) because neither cash (asset) nor revenue (equity) weren’t recorded

Practice Problem #5 1. In the year 2019 Coleman Company’s balance in accounts receivable decreased by $18,000. During the year they collected $86,000 from customers for services provided on acc...