ch02 Fundamental of Financial Accounting by Edmonds (4th Edition)

Fundamental
Financial
Accounting
Concepts
Fourth Edition
by
Edmonds, McNair, Milam, Olds
PowerPoint® presentation by
J. Lawrence Bergin
2- 2
Chapter 2
Accounting
for
Accruals
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

2- 3
Difficulties in measuring income:

● Accounting period issue
● Matching issue
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.

2- 4
Examples of Accrual Events

● 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

2- 5
Accounts Receivable--amounts owed by

customers for goods and services received.
● Recognition of event versus
realization of cash
■ recognizing an event means to Accounts Rec.
record it in the accounting records
■ the term is most often used with
respect to recording revenues and
expenses on the income statement
When is revenue realized?
realized
■ when the amounts are earned
(required activities are complete)

2- 6
Accounts Payable--amounts you owe

creditors for the purchase of goods and
services.
When are costs
recognized as INVOICE
expenses?
■ when the “matching”
revenue is
recognized, or
■ when the benefits of
the expenditures are
received

2- 7
Review of Core Concepts

● Asset Source Transactions--an
Transactions asset increases
and a corresponding claims account increases
● Asset Use Transactions--an
Transactions asset decreases and
a corresponding claims account decreases
● Asset Exchange Transactions--one
Transactions asset
increases and another asset decreases
● Claims Exchange Transactions--one
Transactions claims
account increases and another decreases

2- 8
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 transactions

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.
2- 10
Remember, the balance sheet account

balances from the end of 2004 are
the beginning balances (BB) of 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 carried forward.

2- 11
1. During 2005, provided services to

customers for $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.

2- 12
1. During 2005, provided services to

customers for $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.

2- 13
2. Incurred various operating expenses

totaling $1,200 on 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.

2- 14
2. Incurred various operating expenses

totaling $1,200 on 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.

2- 15
3. Collected $1,500 from the 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.

2- 16
3. Collected $1,500 from the 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.

2- 17
4. Paid $1,000 on the accounts payable

recorded 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.

2- 18
4. Paid $1,000 on the accounts payable

recorded 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.

2- 19
5. On Jan. 1, 2005, invested $500 in a

Certificate of Deposit (CD) investment
with a 10% return 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.

2- 20
5. On Jan. 1, 2005, invested $500 in a

Certificate of Deposit (CD) investment
with a 10% return 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.

2- 21
• 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.)
Let’s review how to calculate interest. The basic formula is:
ASSETS = Principal X Rate X Time
LIABILITIES + EQUITY STATEMENT
$ borrowed or invested Time since interest1,650
BB 1,650 1,500 1,000 2,000 150 bal.
ANNUAL rate
1 2,000 2,000 was
2,000 last recorded.
2,000
2 1,200 (1,200) 1,200 (1,200)
On November(1,500)
3 1,500 1, 2004 ABC Company invested $3,000 in a 6%, 3 month CD.
1,500 OA
4 (1,000) (1,000)
How much interest should be accrued on December 31, 2004? (1,000) OA
5 (500) 500 (500) IA
6 Principal X Rate X Time = Interest
7
8 $3,000 X .06 X 2/12 = $30.00
EB + + + +
rate =for 12+mo. + + +
Nov. & Dec. - = bal.

2- 22

(Cash payment of the invested principal and the
interest 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.

2- 23

(Cash payment of the invested principal and the
interest will be made at the end of the term of the
investment.) $500 x .10 x 12/12 = $50
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.

2- 24

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.

2- 25

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.
2- 26
8. Accrued interest on Note Payable

($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.)
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.

2- 27

($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.)
BALANCE SHEET (and Accounting Equation) Jan.1,2005-Dec.31,2005 = 12 Mo.
INCOME STATEMENT CASHFLOW
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
4 (1,000)
$1,000 x .08 x 12/12 = $80
(1,500)
(1,000)
1,500 OA
(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.

2- 28 Ending
Balances
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.

2- 29
Summary of General Ledger Accounts

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

2- 30
Kleen Sweep, Inc.
Income Statement
For the Year Ended December 31, 2005
Revenue
Expenses
Net Income

2- 31
Kleen Sweep, Inc.
Income Statement
Revenue
Services $2,000
Interest 50
Total Revenue $2,050
Expenses
Operating Expenses 1,200
Interest Expense 80
Total Expenses $1,280
Net Income $ 770
2- 32
Kleen Sweep, Inc.
Statement of Changes in Stockholders’
Equity
Beginning Common Stock $
Plus: Common Stock issued
Ending Common Stock

$
Beginning Retained Earnings $
Plus: Net income

Less: Dividends
Ending Retained Earnings
$
2- 33
Kleen Sweep, Inc.

Statement of Changes in Stockholders’
Equity
For the Year
Beginning Ended
Common December$31,
Stock 2005
2000
Plus: Common Stock issued 0
Ending Common Stock $
2,000
Beginning Retained Earnings $
150
Plus: Net income 770
Less: Dividends (100)

Ending Retained Earnings
$ 820
Total Stockholders’ Equity $
2- 34
Kleen Sweep, Inc.
Balance Sheet
At December 31, 2005
Assets
Liabilities
+
Owners’ Equity

2- 35 Kleen Sweep, Inc. Balance Sheet At Dec. 31, 2005
Assets:
Cash $1,550
CD Investment 500
Accounts Receivable 500
Interest Receivable 50
Land 1,500
Total Assets $4,100
Liabilities and Stockholders’ Equity

Accounts Payable $ 200
Interest Payable 80
Note Payable 1,000
Total Liabilities $1,280
Common Stock 2,000
Retained Earnings 820
Total Stockholders’ Equity 2,820
Total Liabilities and Stockholders’ Equity $4,100

2- 36
Kleen Sweep, Inc.
Statement of Cash Flows
Cash 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 Activities
Distributions 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 $

2- 37
Kleen Sweep, Inc.
Cash receipts from Services $ 1,500
Cash recpts. from Interest earned

2- 38
Kleen Sweep, Inc.
Cash recpts. from Interest earned 0

2- 39
Kleen Sweep, Inc.
Cash payments for Oper. Exp. (1,000)

2- 40
Kleen Sweep, Inc.
Cash payments for Interest exp. (0)

2- 41
Kleen Sweep, Inc.
Net cash flow from operations $ 500

2- 42
Kleen Sweep, Inc.
Cash payment for Investment (500)
Net cash flow from investments $ (500)

2- 43
Kleen Sweep, Inc.
Distributions to owners (100)
Net cash flow from financing $ (100)

2- 44
Kleen Sweep, Inc.
Net Increase (Decrease) in cash $ (100)

2- 45
Kleen Sweep, Inc.
Plus: Cash balance on Jan. 1, 2005 1,650
Cash balance on Dec. 31, 2005 $1,550

2- 46
Kleen Sweep, Inc.
Plus: Cash balance on Jan. 1, 2005 1,650
Cash balance on Dec. 31, 2005 $1,550

2- 47
Q: Who is responsible for these

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

2- 48
Q: What assurance do financial

statement users have that the
company prepared them
using “proper” accounting?
A: Read the opinion expressed by

the independent auditor, the
CPA (Certified Public
Accountant), after conducting
a financial audit.

2- 49
Types of Audit Opinions

•Unqualified Opinion
•Adverse Opinion
•Qualified Opinion
•Disclaimer of Opinion

2- 50

•Unqualified Opinion:
Best opinion. It means the statements
used GAAP (Generally Accepted
Accounting Principles) and are a
FAIR representation of the company’s
actual financial condition.
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.

2- 51

•Adverse Opinion:
Worst opinion. It means the statements

did not follow GAAP and the statements
do NOT fairly represent the company’s
actual financial condition .
These opinions are rare because the

company will normally make the changes
requested by the auditor.

2- 52

•Qualified Opinion:
It means the statements followed GAAP for

the most part, but there is some special
situation that needs to be called to the
attention of the statement readers.
The auditor’s report will explain why the

qualified opinion was issued.

2- 53
•Disclaimer of Opinion:
It means the auditor could not

obtain enough information to
determine if the statements
followed GAAP. Therefore, the
auditor could not express an
opinion about the statements.

2- 54
The Importance of Ethics

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

“public” accountants have Codes of
Ethics that must be followed.
2- 55
The Importance of Ethics

Although rare, violations of ethical conduct by
accountants and other business professionals
can shake the confidence in financial reporting.
USA TODAY
Feb. 22, 2002

2- 56
Let’s revisit transaction #8

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. =N/Pay
Cash Payment of interest
+ I/Pay. + C.Stk.(d ) and Rev
+ 1Ret.E. principal (dN.Inc.
- Exp. = 2) on 3/31/06.
CashFlow
a.+1000 =+1000 + n.a. + n.a. + n.a. n.a. - n.a. = n.a. +1000 FA
• 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

2- 57

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 $ $
2- 58

Interest Cash
2004 $ 0 $ 1000 FA
2005 $ $
2006 $ $
Totals $ $
2- 59

Interest Cash
2004 $ 0 $ 1000 FA
2005 $ 80 $ 0
2006 $ $
Totals $ $
2- 60

Interest Cash
2004 $ 0 $ 1000 FA
2005 $ 80 $ 0
2006 $ 20 $(1000) FA (Repay Principal)
(100) OA (Pay all interest)
Totals $ $
2- 61

Interest Cash
2004 $ 0 $ 1000 FA
2005 $ 80 $ 0
2006 $ 20 $(1000) FA (Repay Principal)
(100) OA (Pay all interest)
Totals $ 100 $ (100) net OA
2- 62
Chapter 2:
The End

ch02 Fundamental of Financial Accounting by Edmonds (4th Edition)

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Fundamental

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

Difficulties in measuring income:

What is ACCRUAL ACCOUNTING?

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

Examples of Accrual Events

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

Accounts Receivable--amounts owed by

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

Accounts Payable--amounts you owe

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

Review of Core Concepts

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

Kleen Sweep’s 2005 transactions

Remember, the balance sheet account

Income Statement account balances are NOT carried forward.

1. During 2005, provided services to

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

1. During 2005, provided services to

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

2. Incurred various operating expenses

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

2. Incurred various operating expenses

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

3. Collected $1,500 from the customers

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3. Collected $1,500 from the customers

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4. Paid $1,000 on the accounts payable

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4. Paid $1,000 on the accounts payable

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5. On Jan. 1, 2005, invested $500 in a

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5. On Jan. 1, 2005, invested $500 in a

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• Record interest earned on the CD

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• Record interest earned on the CD

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• Record interest earned on the CD

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7. Paid $100 dividend to stockholders.

BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW

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7. Paid $100 dividend to stockholders.

Remember, dividends are NOT an expense. They are

8. Accrued interest on Note Payable

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8. Accrued interest on Note Payable

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Summary of General Ledger Accounts

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Ending Common Stock

Beginning Retained Earnings $

Plus: Net income

Kleen Sweep, Inc.

Less: Dividends (100)

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Liabilities and Stockholders’ Equity

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