ch02 fundamental of financial accounting by edmonds (4th edition)

Fundamental Fundamental Financial Financial

Accounting Accounting ConceptsConcepts

Fourth EditionFourth Editionbyby

Edmonds, McNair, Milam, OldsEdmonds, McNair, Milam, Olds

PowerPoint® presentation byJ. Lawrence Bergin

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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Chapter 2Chapter 2

Accounting for

Accruals


2- 3

Difficulties in measuring Difficulties in measuring income:income: Accounting period issue

Matching issue

What is ACCRUAL ACCOUNTING?What is ACCRUAL ACCOUNTING?Recording the financial transactions of a business in the period in which they occur, rather than in the period in which cash is exchanged.


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Examples of Accrual Examples of Accrual EventsEvents Sales made “on account”

Purchases made “on credit” Wages expense for employees

»when they’ve worked but you haven’t yet paid them

Interest on money borrowed or lent»when time has passed (so interest has been earned by the lender) but the actual cash for the interest has not changed hands

Income tax expense»when you owe it but haven’t yet paid the IRS


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Accounts Receivable--amounts owed Accounts Receivable--amounts owed by customers for goods and services by customers for goods and services received.received.

RecognitionRecognition of event of event versus realization of cashrealization of cash recognizing recognizing an event means to

record it in the accounting records

the term is most often used with respect to recording revenues and expenses on the income statement

When When is revenue realizedrealized? when the amounts are earned

(required activities are complete)

Accounts Rec.


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Accounts Payable--amounts you Accounts Payable--amounts you owe creditors for the purchase owe creditors for the purchase of goods and services.of goods and services.

When are costs recognized as expenses? when the

“matching” revenue is recognized, or

when the benefits of the expenditures are received

INVOICE


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Review of Core Review of Core ConceptsConcepts Asset Source TransactionsAsset Source Transactions--an asset increases and a corresponding claims account increases

Asset Use TransactionsAsset Use Transactions--an asset decreases and a corresponding claims account decreases

Asset Exchange TransactionsAsset Exchange Transactions--one asset increases and another asset decreases

Claims Exchange TransactionsClaims Exchange Transactions--one claims account increases and another decreases


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.

Note:Note:

The illustration that follows is a continuation of the Kleen Sweep, Inc. transactions we recorded in Chapter #1.

THE TRANSACTIONS WE RECORDED IN CHAPTER #1 ALL OCCURRED IN THE YEAR 2004. We will now record the transactions for the second year of operations which is 2005.


2- 9 Kleen Sweep’s 2005 Kleen Sweep’s 2005 transactionstransactions

1. During 2005, provided services to customers for $2,000 on account. 2. Incurred various operating expenses totaling $1,200 on

credit. 3. Collected $1,500 from the customers in transaction #1. 4. Paid $1,000 on the accounts payable recorded in transaction #2. 5. On Jan. 1, 2005, invested $500 in a Certificate of Deposit (CD) investment with a 10% return and a 36- month term. 6. Record interest earned on the CD investment for the first 12 months. (Cash payment of the invested principal & the interest will be made at the end of the term of the investment.)

7. Paid $100 dividend to stockholders. 8. Accrued interest on Note Payable.


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Remember, the balance sheet Remember, the balance sheet account balances from the account balances from the end of 2004 are the end of 2004 are the beginning balances (BB) of beginning balances (BB) of 2005.2005.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW ASSETS = LIABILITIES + EQUITY STATEMENT

Accts Int. Accts Int. Note Com. Ret. Net OA,IA,FA

Cash + CD + Receiv. + Rec. + Land = Pay. + Pay. + Pay. + Stk. + Earn. Rev. - Exp. = Inc. $ amt

BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1

2

3

4

5

6

7

8

EB + + + + = + + + + - = bal.

Income Statement account balances are NOT Income Statement account balances are NOT carried forward.carried forward.


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1. During 2005, provided 1. During 2005, provided services to customers for services to customers for $2,000 on account.$2,000 on account.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1

2

3

4

5

6

7

8

EB + + + + = + + + + - = bal.


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1. During 2005, provided 1. During 2005, provided services to customers for services to customers for $2,000 on account.$2,000 on account.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2

3

4

5

6

7

8

EB + + + + = + + + + - = bal.


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2. Incurred various operating 2. Incurred various operating expenses totaling $1,200 on expenses totaling $1,200 on credit.credit.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2

3

4

5

6

7

8

EB + + + + = + + + + - = bal.


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2. Incurred various operating 2. Incurred various operating expenses totaling $1,200 on expenses totaling $1,200 on credit.credit.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3

4

5

6

7

8

EB + + + + = + + + + - = bal.


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3. Collected $1,500 from the 3. Collected $1,500 from the customers in transaction #1.customers in transaction #1.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3

4

5

6

7

8

EB + + + + = + + + + - = bal.


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3. Collected $1,500 from the 3. Collected $1,500 from the customers in transaction #1.customers in transaction #1.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4

5

6

7

8

EB + + + + = + + + + - = bal.


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4. Paid $1,000 on the 4. Paid $1,000 on the accounts payable recorded accounts payable recorded in transaction #2.in transaction #2.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4

5

6

7

8

EB + + + + = + + + + - = bal.


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4. Paid $1,000 on the 4. Paid $1,000 on the accounts payable recorded accounts payable recorded in transaction #2.in transaction #2.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5

6

7

8

EB + + + + = + + + + - = bal.


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5. On Jan. 1, 2005, invested $500 5. On Jan. 1, 2005, invested $500 in a Certificate of Deposit (CD) in a Certificate of Deposit (CD) investment with a 10% return investment with a 10% return and a 36 month term.and a 36 month term.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5

6

7

8

EB + + + + = + + + + - = bal.


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5. On Jan. 1, 2005, invested $500 5. On Jan. 1, 2005, invested $500 in a Certificate of Deposit (CD) in a Certificate of Deposit (CD) investment with a 10% return investment with a 10% return and a 36 month term.and a 36 month term.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6

7

8

EB + + + + = + + + + - = bal.


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6.6. Record interest earned on Record interest earned on the CD investment for the the CD investment for the first 12 months.first 12 months. (Cash payment of the invested principal & the interest (Cash payment of the invested principal & the interest will be made at the end of the term of the investment.)will be made at the end of the term of the investment.)




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6

7

8

EB + + + + = + + + + - = bal.

Let’s review how to calculate interest. The basic formula is:

Principal X Rate X Time

$ borrowed or investedANNUAL rate

Time since interest was last recorded.

On November 1, 2004 ABC Company invested $3,000 in a 6%, 3 month CD.

How much interest should be accrued on December 31, 2004?How much interest should be accrued on December 31, 2004?

Principal X Rate X Time = Interest

$3,000 X .06 X 2/12 = $30.00rate for 12 mo. Nov. & Dec.


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6.6. Record interest earned on Record interest earned on the CD investment for the the CD investment for the first 12 months.first 12 months. (Cash payment of the invested principal and the (Cash payment of the invested principal and the interest will be made at the end of the term of the interest will be made at the end of the term of the investment.)investment.)




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6

7

8

EB + + + + = + + + + - = bal.


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6.6. Record interest earned on Record interest earned on the CD investment for the the CD investment for the first 12 months.first 12 months. (Cash payment of the invested principal and the (Cash payment of the invested principal and the interest will be made at the end of the term of the interest will be made at the end of the term of the investment.)investment.)




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6 50 50 50 50

7

8

EB + + + + = + + + + - = bal.

$500 x .10 x 12/12 = $50


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7. Paid $100 dividend to 7. Paid $100 dividend to stockholders.stockholders.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6 50 50 50 50

7

8

EB + + + + = + + + + - = bal.


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7. Paid $100 dividend to 7. Paid $100 dividend to stockholders.stockholders.




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6 50 50 50 50

7 (100) (100) (100) FA

8

EB + + + + = + + + + - = bal.

Remember, dividends are NOT an expense. They are NOT reported on the Income Statement.


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8. Accrued interest on Note 8. Accrued interest on Note PayablePayable




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6 50 50 50 50

7 (100) (100) (100) FA

8

EB + + + + = + + + + - = bal.

($1,000 borrowed on 12/31/04 [recorded in Ch. 1]. Terms are 8% interest to be included with repayment of the principal on 3/31/06.)


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8. Accrued interest on Note 8. Accrued interest on Note PayablePayable




BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6 50 50 50 50

7 (100) (100) (100) FA

8 80 (80) 80 (80)

EB + + + + = + + + + - = bal.

($1,000 borrowed on 12/31/04 [recorded in Ch. 1]. Terms are 8% interest to be included with repayment of the principal on 3/31/06.)

$1,000 x .08 x 12/12 = $80$1,000 x .08 x 12/12 = $80

Jan.1,2005-Dec.31,2005 = 12 Mo.


2- 28 Ending Ending BalancesBalances

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

ASSETS = LIABILITIES + EQUITY STATEMENT



BB 1,650 1,500 1,000 2,000 150 1,650 bal.

1 2,000 2,000 2,000 2,000

2 1,200 (1,200) 1,200 (1,200)

3 1,500 (1,500) 1,500 OA

4 (1,000) (1,000) (1,000) OA

5 (500) 500 (500) IA

6 50 50 50 50

7 (100) (100) (100) FA

8 80 (80) 80 (80)

EB 1,550 + 500 + 500 + 50 + 1,500 = 200 + 80 + 1,000 + 2,000 + 820 2,050 - 1,280 = 770 1,550 bal.


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Summary of General Ledger AccountsSummary of General Ledger Accounts for 2005 Transactions for 2005 Transactions

ACCOUNTING EQUATION

ASSETS = LIABILITIES + STK. EQUITY Titles of Nominal accts.

Accts Int. Accts Int. Note Com. Ret. affected that resulted in

Cash + CD + Receiv. + Rec. + Land = Pay. + Pay. + Pay. + Stk. + Earn. the change in Ret.Earn.

BB 1,650 1,500 1,000 2,000 150

1 2,000 2,000 + Service Rev.

2 1,200 (1,200) + Oper. Expense

3 1,500 (1,500)

4 (1,000) (1,000)

5 (500) 500

6 50 50 + Interest Rev.

7 (100) (100) + Dividend

8 80 (80) + Interest Exp.

EB 1,550 + 500 + 500 + 50 + 1,500 = 200 + 80 + 1,000 + 2,000 + 820


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Kleen Sweep, Inc.Income Statement

For the Year Ended December 31, 2005

Revenue

Expenses

Net Income


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Kleen Sweep, Inc.Income Statement

For the Year Ended December 31, 2005

RevenueServices $2,000Interest 50

Total Revenue $2,050Expenses

Operating Expenses 1,200 Interest Expense 80 Total Expenses

$1,280Net Income $ 770


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Kleen Sweep, Inc.Statement of Changes in Stockholders’

EquityFor the Year Ended December 31, 2005

Beginning Common Stock $ Plus: Common Stock issued Ending Common Stock

$

Beginning Retained Earnings $ Plus: Net income Less: Dividends Ending Retained Earnings $

Total Stockholders’ Equity $


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Kleen Sweep, Inc.Statement of Changes in Stockholders’

EquityFor the Year Ended December 31, 2005Beginning Common Stock $ 2000

Plus: Common Stock issued 0 Ending Common Stock $

2,000Beginning Retained Earnings $

150 Plus: Net income 770 Less: Dividends (100) Ending Retained Earnings

$ 820Total Stockholders’ Equity $

2,820


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Kleen Sweep, Inc. Balance Sheet

At December 31, 2005

Assets

Liabilities +Owners’ Equity


2- 35

Assets:Cash $1,550CD Investment 500Accounts Receivable 500Interest Receivable 50Land 1,500Total Assets $4,100

Liabilities and Stockholders’ EquityAccounts Payable $ 200Interest Payable 80Note Payable 1,000

Total Liabilities $1,280Common Stock 2,000 Retained Earnings 820

Total Stockholders’ Equity 2,820 Total Liabilities and Stockholders’ Equity $4,100

Kleen Sweep, Inc. Balance Sheet At Dec. 31, 2005


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Kleen Sweep, Inc.Statement of Cash Flows

For the Year Ended December 31, 2005Cash from Operations:

Cash receipts from Services $ Cash recpts. from Interest earned Cash payments for Oper. Exp. Cash payments for Interest exp.

Net cash flow from operations $ Cash from Investing Activities:

Cash payment for Investment Net cash flow from investments $

Cash from Financing ActivitiesDistributions to owners

Net cash flow from financing $ Net Increase (Decrease) in cash $ Plus: Cash balance on Jan. 1, 2005 Cash balance on Dec. 31, 2005 $


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Cash receipts from Services $ 1,500 Cash recpts. from Interest earned Cash payments for Oper. Exp. Cash payments for Interest exp.






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Cash receipts from Services $ 1,500 Cash recpts. from Interest earned 0 Cash payments for Oper. Exp. Cash payments for Interest exp.






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Cash receipts from Services $ 1,500 Cash recpts. from Interest earned 0 Cash payments for Oper. Exp. (1,000) Cash payments for Interest exp.






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Cash receipts from Services $ 1,500 Cash recpts. from Interest earned 0 Cash payments for Oper. Exp. (1,000) Cash payments for Interest exp. (0)






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Net cash flow from operations $ 500Cash from Investing Activities:





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Cash payment for Investment (500) Net cash flow from investments $ (500)




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Cash from Financing ActivitiesDistributions to owners (100)

Net cash flow from financing $ (100) Net Increase (Decrease) in cash $ Plus: Cash balance on Jan. 1, 2005 Cash balance on Dec. 31, 2005 $


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Net cash flow from financing $ (100) Net Increase (Decrease) in cash $ (100)Plus: Cash balance on Jan. 1, 2005 Cash balance on Dec. 31, 2005 $


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Net cash flow from financing $ (100) Net Increase (Decrease) in cash $ (100)Plus: Cash balance on Jan. 1, 2005 1,650 Cash balance on Dec. 31, 2005 $1,550


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Net cash flow from financing $ (100) Net Increase (Decrease) in cash $ (100)Plus: Cash balance on Jan. 1, 2005 1,650 Cash balance on Dec. 31, 2005 $1,550


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A: A: Company Company ManagementManagement

In fact, management is In fact, management is encouraged to put a formal encouraged to put a formal statement in its annual report statement in its annual report stating that it is responsible for the stating that it is responsible for the representations in the financial representations in the financial statements.statements.

Q: Who is responsible for these financial statements?


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A: Read the A: Read the opinionopinion expressed by expressed by the independent the independent auditor, auditor, the the CPACPA (Certified Public (Certified Public Accountant), after conducting Accountant), after conducting

a financial a financial auditaudit..

Q: What assurance do financial statement users have that the company prepared them

using “proper” accounting?


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Types of Audit Opinions•Unqualified Unqualified OpinionOpinion

•Adverse OpinionAdverse Opinion

•Qualified OpinionQualified Opinion

•Disclaimer of Disclaimer of OpinionOpinion


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•Unqualified OpinionUnqualified Opinion::Best opinion.Best opinion. It means the It means the

statements statements used GAAP used GAAP (Generally Accepted (Generally Accepted Accounting Principles) and are a Accounting Principles) and are a

FAIR representation of the FAIR representation of the company’s company’s actual financial actual financial condition.condition.

Types of Audit Opinions

It is up to the statement reader to decide if the company is in GOOD financial condition. The auditor only states that the statements fairly

present the actual financial condition.


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•Adverse OpinionAdverse Opinion::

Worst opinionWorst opinion. It means the . It means the statements did not follow GAAP statements did not follow GAAP and the statements do NOT fairly and the statements do NOT fairly represent the company’s actual represent the company’s actual financial condition . financial condition .

These opinions are These opinions are rare rare because because the company will normally make the company will normally make the changes requested by the the changes requested by the auditor. auditor.



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•Qualified OpinionQualified Opinion::

It means the statements followed It means the statements followed GAAP GAAP for the most part, but there , but there is some special situation that is some special situation that needs to be called to the attention needs to be called to the attention of the statement readers. of the statement readers.

The auditor’s report will explain The auditor’s report will explain why the qualified opinion was why the qualified opinion was issued.issued.



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•Disclaimer of Disclaimer of OpinionOpinion::

It means the auditor could It means the auditor could notnot obtain enough obtain enough information to determine if information to determine if the statements followed the statements followed GAAP. Therefore, the GAAP. Therefore, the auditor could auditor could notnot express express an opinionan opinion about the about the statements. statements.



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High ethical standards on the High ethical standards on the part of the accountants part of the accountants (management) who prepare the (management) who prepare the financial statements and the financial statements and the independent CPAs who audit independent CPAs who audit them are absolutely necessary them are absolutely necessary for accounting to perform its for accounting to perform its role in society. role in society.

Both “management” Both “management” accountants and “public” accountants and “public” accountants have Codes of accountants have Codes of Ethics that must be followed.Ethics that must be followed.

The Importance of Ethics


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Although rare, violations of ethical conduct by accountants and other business professionals can shake the confidence in financial reporting.

The Importance of Ethics

USA TODAYFeb. 22, 2002


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Let’s revisit transaction Let’s revisit transaction #8#88.8. Accrued interest on Note Payable a. $1,000 borrowed on 12/31/04; terms were 8% interest to be included with principal repayment on 3/31/06.)b. Adjustment to accrue interest on 12/31/05.c. Accrual of interest from 01/01/06 thru 03/31/06d. Payment of interest (d1) and principal (d2) on 3/31/06.

Cash =N/Pay + I/Pay. + C.Stk. + Ret.E. Rev - Exp. = N.Inc. CashFlow

a.+1000 =+1000 + n.a. + n.a. + n.a. n.a. - n.a. = n.a. +1000 FA

b. n.a. = n.a. + 80 + n.a. + (80) n.a. - 80 = (80)

n.a.

c. n.a. = n.a. + 20 + n.a. + (20) n.a. - 20 = (20) n.a.

d1. (100) = n.a. + (100) + n.a. + n.a. n.a. - n.a. = n.a. (100)OA

d2.(1000) =(1000)+ n.a. + n.a. + n.a. n.a. - n.a. = n.a.

(1000)FA


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Let’s revisit transaction #8Let’s revisit transaction #88.8. Accrued interest on Note Payable a. $1,000 borrowed on 12/31/04; terms were 8% interest to be included with principal repayment on 3/31/06.)b. Adjustment to accrue interest on 12/31/05.c. Accrual of interest from 01/01/06 thru 03/31/06.d. Payment of interest (d1) and principal (d2) on 3/31/06. When is the expense recognized vs. the cash paid?

Interest Cash Expense Inflow (Outflow)

2004 $ $2005 $ $ 2006 $ $

Totals $ $


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2004 $ 0 $ 1000 FA2005 $ $ 2006 $ $

Totals $ $


2- 59



2004 $ 0 $ 1000 FA2005 $ 80 $ 02006 $ $

Totals $ $


2- 60



2004 $ 0 $ 1000 FA2005 $ 80 $ 02006 $ 20 $(1000) FA (Repay Principal)

(100) OA (Pay all interest)

Totals $ $


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2004 $ 0 $ 1000 FA2005 $ 80 $ 02006 $ 20 $(1000) FA (Repay Principal)

(100) OA (Pay all interest)

Totals $ 100 $ (100) net OA


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Chapter 2:Chapter 2:

The End

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ch02 fundamental of financial accounting by edmonds (4th edition)