Download - ©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Three Accounting for Deferrals
©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin
Chapter Three
Accounting for Deferrals
Deferral AccountingA deferral involves
recognizing a revenue or expense at
some time after cash has been
collected or paid.
Let’s use seven
transactions for Marketing
Magic, Inc. (MMI) to illustrate
accounting for deferrals.
Event 1: MMI acquired $1,000 cash by issuing common stock.
1. Increase assets (cash).
2. Increase stockholders’ equity (common stock).
Asset Source
Transaction
= Liab. +
Cash + Computer
Equip. - Accum.
Depr. =
Unearned Revenue +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
1,000 + n/a - n/a = n/a + 1,000 + n/a n/a - n/a = n/a 1,000 FA
Assets Stockholders' Equity
Cash Flow
By now, you should be pretty familiar with this type of transaction.
Event 2: On January 1, 2004, MMI received $72,000 cash in advance from Westberry for services to be performed from March 1, 2004, through February 28, 2005.
1. Increase assets (cash).
2. Increase liabilities (unearned revenue).
Asset Source
Transaction
= Liab. +
Cash + Computer
Equip. - Accum.
Depr. =
Unearned Revenue +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
72,000 + n/a - n/a = 72,000 + n/a + n/a n/a - n/a = n/a 72,000 OA
Assets Stockholders' Equity
Cash Flow
Event 3: MMI signed contracts to provide $58,000 of marketing services in 2005.
= Liab. +
Cash + Computer
Equip. - Accum.
Depr. =
Unearned Revenue +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
n/a + n/a - n/a = n/a + n/a + n/a n/a - n/a = n/a n/a
Assets Stockholders' Equity
Cash Flow
Event 4: MMI paid $12,000 cash to purchase computer equipment.
1. Increase assets (computer equipment).
2. Decrease assets (cash).
Asset Exchange
Transaction
= Liab. +
Cash + Computer
Equip. - Accum.
Depr. =
Unearned Revenue +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
(12,000) + 12,000 - n/a = n/a + n/a + n/a n/a - n/a = n/a (12,000) IA
Assets Stockholders' Equity
Cash Flow
Event 5: MMI adjusted its accounts to recognize the revenue earned in 2004.
1. Decrease liabilities (unearned revenue).
2. Increase stockholders’ equity (retained earnings).
Claims Exchange
Transaction
= Liab. +
Cash + Computer
Equip. - Accum.
Depr. =
Unearned Revenue +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
n/a + n/a - n/a = (60,000) + n/a + 60,000 60,000 - n/a = 60,000 n/a
Assets Stockholders' Equity
Cash Flow
$ 72,000 12 months 6,000$ 10 months
$6,000 per month $60,000 revenue in 2004
Event 6: MMI adjusted its accounts to recognize the expense of using the computer equipment during 2004. The equipment was purchased on January 1, 2004 at a cost of $12,000. It had an expected life of four years and a $2,000 salvage value.
1. Decrease assets (accumulated depreciation).
2. Decrease stockholders’ equity (retained earnings).
Asset Use Transaction
= Liab. +
Cash + Computer
Equip. - Accum.
Depr. =
Unearned Revenue +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
n/a + n/a - 2,500 = n/a + n/a + (2,500) n/a - 2,500 = (2,500) n/a Cash Flow
Assets Stockholders' Equity
(Cost Salvage Value) = Depreciation Expense($12,000 $2,000) = $2,500
Straight-Line Depreciation Useful Life
4 years
Accumulated Depreciation and Book Value
Book Value = Cost - Accumulated Depreciation
Accumulated
Depreciation
Contra Asset
Account
Event 7: MMI paid a $50,000 cash dividend to the stockholders.
1. Decrease assets (cash).
2. Decrease stockholders’ equity (retained earnings).
Asset Use Transaction
= Liab. +
Cash + Computer
Equip. - Accum.
Depr. =
Unearned Revenue +
Common Stock +
Retained Earnings Revenue - Expenses =
Net Income
(50,000) + n/a - n/a = n/a + n/a + (50,000) n/a - n/a = n/a (50,000) FA Cash Flow
Assets Stockholders' Equity
Ledger Accounts
Now, let’s prepare the financial statements for MMI using the data
presented above.
= +
(1) 1,000 (2) 72,000 (1) 1,000 (2) 72,000 (5) (60,000) (4) (12,000) Bal. 12,000
(7) (50,000) Bal. - Bal. 11,000
(5) 60,000 (4) 12,000
(6) (2,500) (6) (2,500)
(7) (50,000)
Assets Liabilities Stockholders' EquityCash Unearned Revenue Common Stock
Retained Earnings
Computer Equipment
Depreciation Exp.Accumulated Depr.
Service Revenue
Dividends
Preparing Financial Statements
Service Revenue 60,000$ Depreciation Expense (2,500) Net Income 57,500$
Beginning Common Stock -$ Plus: Common Stock Issued 1,000 Ending Common Stock 1,000$ Beginning Retained Earnings -$ Plus: Net Income 57,500 Less: Dividends (50,000) Ending Retained Earnings 7,500 Total Stockholders' Equity 8,500$
MARKETING MAGIC, INC.Income Statement
For the Year Ended December 31, 2004
Preparing Financial Statements
AssetsCash 11,000$ Computer Equipment 12,000 Less: Accumulated Depreciation (2,500) 9,500 Total Assets 20,500$
LiabilitiesUnearned Revenue 12,000$
Stockholders' EquityCommn Stock 1,000$ Retained Earnings 7,500 Total Stockholders' Equity 8,500 Total Liabilities and Stockholders' Equity 20,500$
As of December 31, 2004
MARKETING MAGIC, INC.Balance Sheet
Preparing Financial Statements
Cash Flows from Operating ActivitiesCash Receipts from Customers 72,000$ Cash Flows for Investing ActivitiesCash Payment for Computer Equipment (12,000) Cash Flows from Financing ActivitiesCash Receipts from Issuing Common Stock 1,000$ Cash Payment for Dividends (50,000) Net Cash Flows from Financing Activities (49,000) Net Increase in Cash 11,000 Plus Beginning Cash Balance - Ending Cash Balance 11,000$
MARKETING MAGIC, INC.Statement of Cash Flows
For the Year Ended December 31, 2004
The Matching ConceptThree Common Matching Practices
1. Costs may be matched directly with the revenues they generate.
2. The costs of items with short or undeterminable useful lives are matched with the period in which they are incurred.
3. The costs of long-term assets with identifiable useful lives are systematically allocated over the assets’ useful lives.
Prepaid Expenses
SuppliesPrepaid Insuranc
e
Prepaid Rent
CostExpense
Expense
Asset
Second Accounting Cycle Event 1 Acquired additional $5,000 cash from issuing common stock. Event 2 Paid $400 cash for supplies Event 3 Paid $1,200 cash for an insurance policy that provided coverage for one
year beginning February 1, 2005.
Event 4 Recognized revenue for $108,000 of services provided on account. Event 5 Collected $89,000 of the receivables due from customers. Event 6 Recognized $32,000 of operating expenses purchased on account. These
are expenses in addition to supplies and insurance and are classified as other operating expenses.
Event 7 Paid suppliers $28,000 of the amount owed on accounts payable. Event 8 Paid a $70,000 cash dividend to stockholders. Event 9 Purchased land for $3,000.
Event 10 Recognized the remainder of the unearned revenue. All services had been provided by February 28, 2005, as specified in the orpginal contract with Westberry.
Event 11 Recognized 2005 depreciation expense. Event 12 Recognized supplies expense; $150 of supplies were on hand at the
close of business on December 31, 2005. Event 13 Recognized insurance expense for 11 months.
Adjusting Entries
MMI experienced the following transactions during 2005:
Let’s focus on the
last two
events.
Event 12: Recognized supplies expense; $150 of supplies was on hand at the close of business on December 31, 2005.
1. Decrease assets (supplies).
2. Decrease stockholders’ equity (retained earnings).
Asset Use Transaction
Beginning Balance
+ Purchases =Asset
Available for Use
-Ending
Balance=
Asset Used
-$ + 400$ = 400$ - 150$ = 250$
Event 13: Recognized insurance expense for 11 months.
1. Decrease assets (prepaid insurance).
2. Decrease stockholders’ equity (retained earnings).
Asset Use Transaction
$ 1,200 12 months 100$ 11 months
$100 per month $1,100 expense in 2004
Now, let’s look at the summary of the ledger accounts at the end of 2005.
= +
Bal. 11,000 Bal. - Bal. - Bal. 1,000 (1) 5,000 (3) 1,200 (6) 32,000 (1) 5,000 (2) (400) (13) (1,100) (7) (28,000) Bal. 6,000
(3) (1,200) Bal. 100 Bal. 4,000
(5) 89,000 (7) (28,000) Bal. 7,500 (8) (70,000) (4) 12,000 Bal. 12,000 (9) (3,000) (10) (12,000) Bal. 2,400 Bal. - (4) 108,000
Bal. (2,500) (10) 12,000 (11) (2,500) Bal. 120,000
Bal. - Bal. (5,000)
(4) 108,000 (5) (89,000) (6) (32,000) Bal. 19,000 Bal. -
(9) 3,000 Bal. 3,000 (11) (2,500)
Bal. - (2) 400 (12) (250) (12) (250) Bal. 150
(13) (1,100)
(8) (70,000)
Supplies Expense
Insurance Exp.
Stockholders' Equity
Computer Equipment
Accumulated Depr.
Land
Unearned Revenue
Service Revenue
Dividends
Supplies
Prepaid Insurance
Retained Earnings
Accounts Receivable
Other Operating Exp.
Depreciation Exp.
LiabilitiesCash Accounts Payable Common Stock
Assets
Now, let’s prepare the 2005 financial statements.
Preparing Financial Statements
Service Revenue 120,000$ Operating Expenses 32,000$ Depreciation Expense 2,500 Supplies Expense 250 Insurance Expense 1,100 Total Expenses (35,850) Net Income 84,150$
Beginning Common Stock 1,000$ Plus: Common Stock Issued 5,000 Ending Common Stock 6,000$ Beginning Retained Earnings 7,500$ Plus: Net Income 84,150 Less: Dividends (70,000) Ending Retained Earnings 21,650 Total Stockholders' Equity 27,650$
MARKETING MAGIC, INC.Income Statement
For the Year Ended December 31, 2005
Preparing Financial Statements
AssetsCash 2,400$ Accounts Receivable 19,000 Supplies 150 Prepaid Insurance 100 Computer Equipment 12,000$ Less: Accumulated Depreciation (5,000) 7,000 Land 3,000 Total Assets 31,650$
LiabilitiesAccounts Payable 4,000$
Stockholders' EquityCommn Stock 6,000$ Retained Earnings 21,650 Total Stockholders' Equity 27,650 Total Liabilities and Stockholders' Equity 31,650$
As of December 31, 2005
MARKETING MAGIC, INC.Balance Sheet
Preparing Financial Statements
Cash Flows from Operating ActivitiesCash Receipts from Customers 89,000$ Cash Payments for Supplies (400)$ Cash Payments for Insurance (1,200) Cash Payments for Operating Expenses (28,000) (29,600) Net Cash Flows from Operating Activities 59,400$ Cash Flows for Investing ActivitiesCash Outflow to Purchase Land (3,000) Cash Flows from Financing ActivitiesCash Receipts from Issuing Common Stock 5,000$ Cash Payment for Dividends (70,000) Net Cash Flows from Financing Activities (65,000) Net Increase in Cash (8,600) Plus Beginning Cash Balance 11,000 Ending Cash Balance 2,400$
MARKETING MAGIC, INC.Statement of Cash Flows
For the Year Ended December 31, 2005
Third Accounting Cycle Event 1 Acquired additional $1,000 cash from issuing common stock. Event 2 Sold the land for $2,500 cash. Event 3 Paid $400 cash for more supplies. Event 4 Borrowed $20,000 from a local bank on February 1, 2006. The note
issued had a 9 percent interest rate and a one-year term. Event 5 Paid $1,200 cash to renew the insurance policy for a one-year term
beginning February 1, 2006. Event 6 Recognized revenue for $167,000 of services provided on account. Event 7 Collected $129,000 of the receivables due from customers. Event 8 Recognized $62,000 of accrued operating expenses, other than supplies
and insurance, charged on account. Event 9 Paid suppliers $65,000 of the amount owed on accounts payable. Event 10 Received $18,000 cash in advance from a customer for marketing
services to be performed for a one-year period beginning December 1, 2006.
Event 11 Paid an $80,000 cash dividend to stockholders.
Event 12 Recognized one-month of the unearned revenue. Event 13 Recognized 2006 depreciation expense. Event 14 Recognized supplies expense; $200 of supplies was on hand at the close
of business on December 31, 2006. Event 15 Recognized insurance expense for 12 months. Event 16 Recognized accrued interest on the bank note.
Adjusting Entries
MMI experienced the following transactions during 2006:
Let’s focus
on Event 2 and Event
16.
Event 2: Sold the land for $2,500 cash.
1. Decrease assets (land).
2. Increase assets (cash).
3. Decrease stockholders’ equity (retained earnings).
Asset Exchange
Transaction
Gains and Losses
Book Value < Cash = GainBook Value > Cash = Loss
Event 16: Recognized the accrued interest on the bank note.
1. Increase liabilities (interest payable).
2. Decrease stockholders’ equity (retained earnings).
Claims Exchange
Transaction
Principal
Annual interest
rate Time
outstanding = Interest
expense
20,000$ 0.09 11/12 = 1,650$
Ledger Accounts= +
Bal. 2,400 Bal. 100 Bal. 4,000 Bal. 6,000 (16) (1,650) (1) 1,000 (5) 1,200 (8) 62,000 (1) 1,000 (2) 2,500 (15) (1,200) (9) (65,000) Bal. 7,000
(3) (400) Bal. 100 Bal. 1,000 (2) (500)
(4) 20,000 (5) (1,200) Bal. 21,650 (7) 129,000 Bal. 12,000 Bal. - (11) (80,000) (9) (65,000) (10) 18,000 (10) 18,000 (12) (1,500) (6) 167,000 (11) (80,000) Bal. 16,500 (12) 1,500
Bal. 26,300 Bal. 168,500
Bal. (5,000) (13) (2,500) (16) 1,650
Bal. 19,000 Bal. (7,500) (8) (62,000)
(6) 167,000 (7) (129,000) (4) 20,000 Bal. 57,000 Bal. 3,000 (13) (2,500)
(2) (3,000) Bal. -
Bal. 150 (14) (350) (3) 400 (13) (350) Bal. 200 (15) (1,200)
LiabilitiesCash Accounts Payable Common Stock
AssetsInterest Expense
Loss on Sale of Land
DividendsRetained Earnings
Supplies
Prepaid Insurance
Accounts Receivable
Stockholders' Equity
Computer Equipment
Accumulated Depr.
Land
Unearned Revenue
Service Revenue
Interest Payable
Notes Payable
Insurance Exp.
Operating Expenses
Depreciation Exp.
Supplies Expense
Now, let’s prepare the 2006 financial
statements.
Preparing Financial Statements
Service Revenue 168,500$ Operating Expenses 62,000$ Depreciation Expense 2,500 Supplies Expense 350 Insurance Expense 1,200 Total Expenses (66,050) Operating Income 102,450 Less: Interest Expense (1,650) Less: Loss on Sale of Land (500) Net Income 100,300$
Beginning Common Stock 6,000$ Plus: Common Stock Issued 1,000 Ending Common Stock 7,000$ Beginning Retained Earnings 21,650$ Plus: Net Income 100,300 Less: Dividends (80,000) Ending Retained Earnings 41,950 Total Stockholders' Equity 48,950$
MARKETING MAGIC, INC.Income Statement
For the Year Ended December 31, 2006
Preparing Financial Statements
AssetsCash 26,300$ Accounts Receivable 57,000 Supplies 200 Prepaid Insurance 100 Computer Equipment 12,000$ Less: Accumulated Depreciation (7,500) 4,500 Total Assets 88,100$
LiabilitiesAccounts Payable 1,000$ Unearned Revenue 16,500 Interest Payable 1,650 Notes Payable 20,000 Total Liabilities 39,150$ Stockholders' EquityCommn Stock 7,000$ Retained Earnings 41,950 Total Stockholders' Equity 48,950 Total Liabilities and Stockholders' Equity 88,100$
As of December 31, 2006
MARKETING MAGIC, INC.Balance Sheet
Preparing Financial Statements
Cash Flows from Operating ActivitiesCash Receipts from Customers 147,000$ Cash Payments for Supplies (400)$ Cash Payments for Insurance (1,200) Cash Payments for Operating Expenses (65,000) (66,600) Net Cash Flows from Operating Activities 80,400$ Cash Flows for Investing ActivitiesCash Receipt from Sale of Land 2,500 Cash Flows from Financing ActivitiesCash Receipt from Bank Loan 20,000$ Cash Receipts from Issuing Common Stock 1,000 Cash Payment for Dividends (80,000) Net Cash Flows from Financing Activities (59,000) Net Increase in Cash 23,900 Plus Beginning Cash Balance 2,400 Ending Cash Balance 26,300$
MARKETING MAGIC, INC.Statement of Cash Flows
For the Year Ended December 31, 2006
Return on Assets Ratio
Net IncomeTotal Assets
Evaluating performance requires considering the size of the
investment base used to produce the income.
This ratio measures the relationship between the level of income and the size of the investment. A larger ratio means the company did a better job
of managing its assets.
Debt to Assets Ratio
Total DebtTotal Assets
Borrowing money is risky business. This ratio helps evaluate the level of
debt risk.
A smaller ratio indicates that there is less debt risk for the company.
Return on Equity Ratio
Net IncomeStockholders’
Equity
Owners are interested in this ratio to determine their return on their
investment in the company.
A larger ratio indicates that the owners have a higher return on their
investment.
Stockholders like a lot of debt if the company can
take advantage of positive financial
leverage.
Creditors prefer less debt and more equity because equity represents a buffer
of protection.
Stockholders vs. Creditors
End of Chapter Three