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Fundamental

Financial
Accounting
Concepts
Fourth Edition
by
Edmonds, McNair, Milam, Olds

PowerPoint® presentation by
J. Lawrence Bergin
3- 2

Chapter 3

Accounting
for
Deferrals

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


3- 3

What is a deferral?
◆ A deferral event occurs when:
– cash is received before revenue
is earned
or
- cash is paid before an expense
is incurred.

◆ Deferral events are a part of the


accrual basis of accounting

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


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Accruals vs. Deferrals (Revenues)


◆ Accrual event
Now Later
Business action Cash exchange
Performed Services Collect receivables
on account later.
◆ Deferral event
Now Later
Cash exchange Business action
Collected Cash from customers, Perform the services we
but services not yet performed. have already been paid for.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Accruals vs. Deferrals (Expenses)


◆ Accrual event
Now Later
Business action Cash exchange
Incurred expense on credit. Use cash to pay for expense
(Haven’t paid yet.) previously recorded.
◆ Deferral event
Now Later
Cash exchange Business action
Pay Cash now for something that Record an EXPENSE when item
will not be EXPENSED until later. purchased before is used up.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Deferred Expenses:
You’ve paid the cash “up-front” but you haven’t
received the goods or services yet.

Prepaid Expenses Prepaid


Prepaid Rent
Prepaid Insurance Expenses are
Supplies ASSETS!
Asset Exchange:
Cash asset is decreased
Prepaid Expense asset
is increased.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
Deferred Expenses related to
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Buildings & Equipment:


You’ve purchased an asset that will be used to benefit more
than one year of operations. When you buy the asset you do
NOT “expense” it. You postpone (defer) the recognition of
the expense until you have used the asset over a period of
time.
Depreciation
of plant (buildings) and equipment

Recognizing an expenditure by spreading it over


several years, allocating a part of the expense to
each of several periods during which the asset is
used, is called depreciation.

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


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Depreciation
◆ The portion of the cost of an
asset allocated to any one
accounting period is called--
DEPRECIATION EXPENSE
◆ Depreciation of an asset is an
allocation process--spreading
the cost of an asset that benefits
more than one accounting
period over the estimated useful
life of the asset.

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


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Example of Depreciation:

◆ ABC Co. bought a


satellite dish for
$6000. The asset is
expected to last five
years and have a
$1,000 salvage value
at the end of its useful
life. How will the
purchase and use of
the asset affect the
financial statements?

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


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◆ We want to allocate the cost of the asset to the income


statement as an expense during the time period we use the
asset. Why?
To comply with the MATCHING principle.
Expenses incurred must be “matched” to the same
time period the revenues (from using this equipment)
are recorded.
◆ If we depreciate the asset using the STRAIGHT LINE
method, we will divide the cost of the asset (minus any
estimated salvage value) by the useful life:
(6000-1000)/5 yrs. = $1000 depreciation expense each year.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Effect on the financial statements:


Purchase of asset:
✿Balance Sheet

✿Income Statement

✿Statement of Changes in Stockholders’ Equity

✿Statement of Cash Flows

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


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Effect on the financial statements:


Purchase of asset:
✿Balance Sheet
◆ Increases assets (eg. Equip); may decrease “cash” asset
(thus, no effect on net assets) or may increase a
liability
✿Income Statement

✿Statement of Changes in Stockholders’ Equity

✿Statement of Cash Flows

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


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Effect on the financial statements:


Purchase of asset:
✿Balance Sheet
◆ Increases assets; may decrease an asset (cash) or increase
a liability (payable) if we haven’t paid yet.
✿Income Statement
◆ No effect
✿Statement of Changes in Stockholders’ Equity

✿Statement of Cash Flows

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


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Effect on the financial statements:


Purchase of asset:
✿Balance Sheet
◆ Increases assets; may decrease an asset (cash) or increase
a liability (payable) if we haven’t paid yet.
✿Income Statement
◆ No effect
✿Statement of Changes in Stockholders’ Equity
◆ No effect
✿Statement of Cash Flows

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


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Effect on the financial statements:


Purchase of asset:
✿Balance Sheet
◆ Increases assets; may decrease an asset (cash) or increase
a liability (payable) if we haven’t paid yet.
✿Income Statement
◆ No effect
✿Statement of Changes in Stockholders’ Equity
◆ No effect
✿Statement of Cash Flows
◆ Depends on whether or not the asset was purchased for
cash. If cash is paid it is an Investing Activity cash flow.

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


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Use of the asset:

✿Balance Sheet

✿Income Statement

✿Statement of Changes in Stockholders’ Equity

✿Statement of Cash Flows

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


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Use of the asset:


◆ Balance Sheet
◆ Reduces the net value of the asset by increasing a
contra-asset called accumulated depreciation
◆ Income Statement

◆ Statement of Changes in Stockholders’ Equity

◆ Statement of Cash Flows

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


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Use of the asset:


◆ Balance Sheet
◆ Reduces the net value of the asset by increasing a
contra-asset called accumulated depreciation
◆ Income Statement
◆ Increase in depreciation expense reduces Net Income

◆ Statement of Changes in Stockholders’ Equity

◆ Statement of Cash Flows

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


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Use of the asset:


◆ Balance Sheet
◆ Reduces the net value of the asset by increasing a
contra-asset called accumulated depreciation
◆ Income Statement
◆ Increase in depreciation expense reduces Net Income
◆ Statement of Changes in Stockholders’ Equity
◆ Since the Net Income decreased, the remaining
Retained Earnings will decrease causing total
Stockholders’ Equity to decrease.
◆ Statement of Cash Flows

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


3- 20

Use of the asset:


◆ Balance Sheet
◆ Reduces the net value of the asset by increasing a
contra-asset called accumulated depreciation
◆ Income Statement
◆ Increase in depreciation expense reduces Net Income
◆ Statement of Changes in Stockholders’ Equity
◆ Since the Net Income decreased, the remaining
Retained Earnings will decrease causing total
Stockholders’ Equity to decrease.
◆ Statement of Cash Flows
◆ No cash involved. Depreciation is an adjusting entry.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Deferred Revenue
◆ You’ve received payment for something
you have NOT yet provided.
◆ Revenue is not recognized until the
service is performed or the goods are
delivered...but you have to record the
fact that you have received the cash,
and….
◆ A related LIABILITY (Unearned
Revenue) must be recorded and kept on
the books until you EARN the revenue.

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


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Below is the horizontal statements model (with


beginning balances) for Bob Company, Inc.
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 =
2 =
3 =
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

Record the following nine transactions for the year ended 12/31/04.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Bob Company’s 2004 transactions


1. Performed services for customers, charging $7,000 on
account.
2. Collected $8,000 cash from customers for services to
be provided in the future.
3. Collected $7,000 of the receivables.
4. Paid $2,000 salaries in cash.
5. On July 1st purchased office equipment by paying
$9,000 cash. (estimates: life=4 years, salvage value=$1,000)
6. On Nov. 1st paid $3,000 to rent office space for the
next three months.
7. Year-end adjustment recognizing 1/4 of the services
required by transaction #2 have been performed.
8. Year-end depreciation adjustment.
9. Year-end rent adjustment.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
3- 24

1. Bob performed services for customers


for $7,000 on account.
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 =
2 =
3 =
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


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1. Performed services for customers for


$7,000 on account.
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 =
3 =
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


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2. Collected $8,000 cash from customers


for services to be provided in the future.
future
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 =
3 =
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


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2. Collected $8,000 cash from customers


for services to be provided in the future.
future
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 =
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


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3. Collected $7,000 of the receivables.


  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 =
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


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3. Collected $7,000 of the receivables.


  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


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4. Paid $2,000 salaries in cash.


  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 =
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


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4. Paid $2,000 salaries in cash.


  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

Salary Expense
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
3- 32

5. On July 1 purchased office


equipment by paying $9,000 cash.
   The equipment is expected to last 4 yrs. with a $1,000 salvage value.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 =
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


3- 33

5. On July 1 purchased office


equipment by paying $9,000 cash.
   The equipment is expected to last 4 yrs. with a $1,000 salvage value.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


3- 34

6. On Nov. 1 paid $3,000 to rent office


space for the next three months.
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 =
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


3- 35

6. On Nov. 1 paid $3,000 to rent office


space for the next three months.
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


3- 36

7. Year-end adjustment recognizing one-fourth


of our work related to event #2 is completed.
   $8,000 in advance x ¼ completed = $2,000 Service Revenue earned.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 =
8 =
9 =
EB + + + - = + + - = bal.

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


3- 37

7. Year-end adjustment recognizing one-fourth


of our work related to event #2 is completed.
   $8,000 in advance x ¼ completed = $2,000 Service Revenue earned.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 = (2,000) 2,000 2,000 2,000
8 =
9 =
EB + + + - = + + - = bal.

McGraw-Hill/Irwin
Service Revenue © The McGraw-Hill Companies, Inc., 2003
3- 38

8. Year-end adjustment to recognize the


depreciation of office equipment.
  
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 = (2,000) 2,000 2,000 2,000
8 =
9 =
EB + + + - = + + - = bal.

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


3- 39

8. Year-end adjustment to recognize the


Cost
depreciation of office equipment.
($9,000-$1,000) /4 Yrs. = $2,000 per yr. Only owned and used for six months
  Salvage (July-Dec.) this year. So, expense is $2,000 x 6/ = $1,000.
12
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. - Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 = (2,000) 2,000 2,000 2,000
8 =
9 =
EB + + + - = + + - = bal.

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


3- 40

8. Year-end adjustment to recognize the


Cost
depreciation of office equipment.
($9,000-$1,000) /4 Yrs. = $2,000 per yr. Only owned and used for six months
  Salvage (July-Dec.) this year. So, expense is $2,000 x 6/ = $1,000.
12
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. -- Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 Accumulated Depreciation
8,000 = is a
8,000 8,000 OA
3 7,000 (7,000) 7,000 OA
4
CONTRA-ASSET.
(2,000)
It is =
(2,000) 2,000 (2,000) (2,000) OA
=
5 SUBTRACTED9,000
(9,000) from the= other assets (9,000) I A
6 to calculate
(3,000) 3,000 the Total Assets.
= (3,000) OA
7 = (2,000) 2,000 2,000 2,000
8 1,000 = (1,000) 1,000 (1,000)
9
Adding to =
EB Accumulated
+ + Deprec.
+ - = + + - = bal.

McGraw-Hill/Irwin
Depreciation Expense © The McGraw-Hill Companies, Inc., 2003
3- 41

9. Year-end adjustment to recognize expired


(used up) rent.
   $3,000 /3 Mo. = $1,000 per mo. Two months (Nov. & Dec.) expired = $2,000.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. - Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 = (2,000) 2,000 2,000 2,000
8 1,000 = (1,000) 1,000 (1,000)
9 =
EB + + + - = + + - = bal.

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9. Year-end adjustment to recognize expired


(used up) rent.
   $3,000 /3 Mo. = $1,000 per mo. Two months (Nov. & Dec.) expired = $2,000.
BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. - Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 = (2,000) 2,000 2,000 2,000
8 1,000 = (1,000) 1,000 (1,000)
9 (2,000) = (2,000) 2,000 (2,000)
EB + + + - = + + - = bal.

Rent Expense
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003
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Summary and Ending Balances


   BALANCE SHEET (and Accounting Equation) INCOME STATEMENT CASHFLOW
ASSETS = LIABILITY + STK. EQUITY STATEMENT
Accts. Prepaid Office Accum. Unearned Com. Retain. Net                OA,IA,FA
Cash + Receiv. + Rent + Equip. - Deprec. = Serv.Rev. + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 5,000 4,000 = 7,000 2,000 5,000 bal.
1 7,000 = 7,000 7,000 7,000
2 8,000 = 8,000 8,000 OA
3 7,000 (7,000) = 7,000 OA
4 (2,000) = (2,000) 2,000 (2,000) (2,000) OA
5 (9,000) 9,000 = (9,000) I A
6 (3,000) 3,000 = (3,000) OA
7 = (2,000) 2,000 2,000 2,000
8 1,000 = (1,000) 1,000 (1,000)
9 (2,000) = (2,000) 2,000 (2,000)
EB 6,000 + 4,000 + 1,000 + 9,000 - 1,000 = 6,000 + 7,000 + 6,000 9,000 - 5,000 = 4,000 6,000 bal.

Subtract the contra-asset, Accum. Dep.


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Summary of General Ledger Accounts


ACCOUNTING EQUATION
ASSETS = LIABILITY + STK. EQUITY   Titles of Nominal accts.
Accts Prepd Office Accum. Unearned Com. Ret.   affected that resulted in
Cash + Receiv. + Rent + Equip. - Deprec. = Serv. Rev. + Stk. + Earn.   the change in Ret.Earn.
BB 5,000 4,000 7,000 2,000
1 7,000 7,000 + Service Revenue
2 8,000 8,000
3 7,000 (7,000)
4 (2,000) (2,000) + Salary Expense
5 (9,000) 9,000
6 (3,000) 3,000
7 (2,000) 2,000 + Service Revenue
8 1,000 (1,000) + Deprec. Exp.
9 (2,000) (2,000) + Rent Expense
EB 6,000 + 4,000 + 1,000 + 9,000 - 1,000 = 6,000 + 7,000 + 6,000

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Bob Company, Inc.
Income Statement
For the Year Ended December 31, 2004
Revenue:
Service revenue $
Other revenue
Total Revenue $
Expenses:
Salary expense $
Depreciation expense
Rent expense
Total Expenses $
Net Income $
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Bob Company, Inc.  INCOME STATEMENT
Income Statement Net
For the Year Ended December 31, 2004 Rev. - Exp. = Inc.

Revenue: 7,000 7,000


Service revenue $9,000
Other revenue 0 2,000  (2,000)
Total Revenue $ 9,000
Expenses: 2,000   2,000
Salary expense $2,000 1,000  (1,000)
Depreciation expense 1,000 2,000  (2,000)
9,000 - 5,000 = 4,000
Rent expense 2,000
Total Expenses $ 5,000
Net Income $ 4,000
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Bob Company, Inc.  INCOME STATEMENT
Income Statement Net
For the Year Ended December 31, 2004 Rev. - Exp. = Inc.

Revenue: 7,000 7,000


Service revenue $9,000
Other revenue 0 2,000  (2,000)
Total Revenue $ 9,000
Expenses: 2,000   2,000
Salary expense $2,000 1,000  (1,000)
Depreciation expense 1,000 2,000  (2,000)
9,000 - 5,000 = 4,000
Rent expense 2,000
Total Expenses $ 5,000
Net Income $ 4,000
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Bob Company, Inc.
Statement of Changes in Stockholders’ Equity
For the Year Ended December 31, 2004
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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Bob Company, Inc.
Statement of Changes in Stockholders’ Equity
For the Year Ended December 31, 2004
Beginning Common Stock $ 7,000
Plus: Common Stock issued 0
Ending Commonn Stock $ 7,000

Beginning Retained Earnings $ 2,000


Plus: Net income 4,000
Less: Dividends 0
Ending Retained Earnings $ 6,000

Total Stockholders’ Equity $13,000

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Bob Company, Inc.
Balance Sheet
As of December 31, 2004

Assets Liabilities
Cash $ Accounts Payable $
Acct. Receivable Unearned Revenue
Total Liabilities $
Prepaid rent
Prop., Plant & Eq.
Stockholders’ Equity
Off. Equip. $ Common Stock $
Accum. Depr. Retained Earnings
Off. Eq., net Total Stkhld. Eq. $
Total Assets $ Total Liab. & S.E. $

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Bob Company, Inc. Property = LAND
Balance Sheet
As of December 31, 2004 Plant = BUILDINGS
Assets Liabilities
Cash $ 6,000 Accounts Payable $ 0
Acct. Receivable 4,000 Unearned Revenue 6,000
Total Liabilities $ 6,000
Prepaid rent 1,000
Prop., Plant & Eq.
Stockholders’ Equity
Off. Equip. $9,000
Common Stock $ 7,000
Accum. Depr. (1,000) Retained Earnings 6,000
Off. Eq., net 8,000 Total Stkhld. Eq. $13,000
Total Assets $19,000
This is the Book Value (or “Carrying Total Liab. & S.E. $19,000
Value”) of the Office Equipment.
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Bob Company, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash from Operations:
Cash receipts for services $
Cash payments for expenses
Net cash flow from operations $
Cash from Investing Activities:
Cash payment for equipment $
Net cash flow from investments $
Cash from Financing Activities
Cash receipts from stock issue
Dividends paid to stockholders’ $
Net cash flow from financing $

Net Increase (Decrease) in cash $


Plus: Cash balance, Jan. 1, 2004
Cash balance, Dec. 31, 2004 $
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Bob Company, Inc. CASHFLOW
Statement of Cash Flows STATEMENT
For the Year Ended December 31, 2004       OA,IA,FA
Cash from Operations: $ amt
Cash receipts for services $ 15,000   5,000  bal. 
Cash payments for expenses (5,000)
Net cash flow from operations $10,000   8,000  OA 
  7,000  OA 
Cash from Investing Activities:  (2,000)  OA 
Cash payment for equipment $(9,000)  (9,000)  I A 
Net cash flow from investments $(9,000)  (3,000)  OA 

Cash from Financing Activities


Cash receipts from stock issue 0
Dividends paid to stockholders’ $ (0)
  6,000  bal. 
Net cash flow from financing $ (0)

Net Increase (Decrease) in cash $ 1,000


Plus: Cash balance, Jan. 1, 2004 5,000
Cash balance, Dec. 31, 2004 $ 6,000
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Bob Company, Inc. CASHFLOW
Statement of Cash Flows STATEMENT
For the Year Ended December 31, 2004       OA,IA,FA
Cash from Operations: $ amt
Cash receipts for services $ 15,000   5,000  bal. 
Cash payments for expenses (5,000)
Net cash flow from operations $10,000   8,000  OA 
  7,000  OA 
Cash from Investing Activities:  (2,000)  OA 
Cash payment for equipment $(9,000)  (9,000)  I A 
Net cash flow from investments $(9,000)  (3,000)  OA 

Cash from Financing Activities


Cash receipts from stock issue 0
Dividends paid to stockholders’ $ (0)
  6,000  bal. 
Net cash flow from financing $ (0)

Net Increase (Decrease) in cash $ 1,000


Plus: Cash balance, Jan. 1, 2004 5,000
Cash balance, Dec. 31, 2004 $ 6,000
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Bob Company, Inc. CASHFLOW
Statement of Cash Flows STATEMENT
For the Year Ended December 31, 2004       OA,IA,FA
Cash from Operations: $ amt
Cash receipts for services $ 15,000   5,000  bal. 
Cash payments for expenses (5,000)
Net cash flow from operations $10,000   8,000  OA 
  7,000  OA 
Cash from Investing Activities:  (2,000)  OA 
Cash payment for equipment $(9,000)  (9,000)  I A 
Net cash flow from investments $(9,000)  (3,000)  OA 

Cash from Financing Activities


Cash receipts from stock issue 0
Dividends paid to stockholders’ $ (0)
  6,000  bal. 
Net cash flow from financing $ (0)

Net Increase (Decrease) in cash $ 1,000


Plus: Cash balance, Jan. 1, 2004 5,000
Cash balance, Dec. 31, 2004 $ 6,000
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Bob Company, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2004
Cash from Operations:
Cash receipts for services $ 15,000
Cash payments for expenses (5,000)
Net cash flow from operations $10,000
Cash from Investing Activities:
Cash payment for equipment $(9,000)
Net cash flow from investments $(9,000)
Cash from Financing Activities
Cash receipts from stock issue 0
Dividends paid to stockholders’ $ (0)
Net cash flow from financing $ (0)

Net Increase (Decrease) in cash $ 1,000


Plus: Cash balance, Jan. 1, 2004 5,000
Cash balance, Dec. 31, 2004 $ 6,000
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Analysis of Financial Statements
Using Ratios
Bob Company’s Net Income is $4,000.
Is this good or bad?
If Bob only invested $1 to start the 
business, a $4,000 profit sounds great.
If he expected a $10,000 profit, he’s not 
happy.
If his competitor only earned $2,000 with a 
similar investment, Bob’s doing OK.

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Analysis of Financial Statements
Using Ratios
For a meaningful analysis we need:
1. a way to compare different size companies
Use financial RATIOS.

2. A basis of comparison.
a. Our past: (Are we getting better?)
b. Our budget: (Did we meet expectations?)
c. Our competitors: Who is better? Why?
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Analysis of Financial Statements
Using Ratios (Data from Bob Co.)
◆ Return on assets
Net income $ %
= =
Total assets $
◆ Debt to assets
Total debt (Liabilities) $ %
= =
Total assets $
◆ Return on equity
Net income $ %
= =
Stockholders’ Equity $
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Analysis of Financial Statements
Using Ratios (Data from Bob Co.)
◆ Return on assets
Net income $ 4,000 21.1%
= =
Total assets $19,000
◆ Debt to assets
Total debt (Liabilities) $ 6,000 31.6%
= =
Total assets $19,000
◆ Return on equity
Net income $ 4,000 30.8%
= =
Stockholders’ Equity $13,000
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Using Financial “Leverage”

Using borrowed money to


increase the return on the
Owners’ (the Stockholders’)
Investment.
Ex: Borrow money at 10% to buy
equipment. Earn 12% investment
return on operating the equipment.
Net 2% increase to owners.
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Chapter 3:

Financial
Accounting

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

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