Chapter 02 - Accounting for Accruals and Deferrals

Chapter 02 - Accounting for Accruals and Deferrals

2-1 Chapter 2

Accounting for Accruals and Deferrals General Comments for Chapter 2

This chapter introduces accrual accounting. A key concept in this chapter is for the stu- dent to understand that revenues earned must be matched with expenses incurred to earn those revenues, regardless of when the cash exchange occurs. You can introduce the sub- ject simply by using a single accounting event in which a business provides services on account. Chapter 1 assumed that all transactions were cash-based, but we all know that reality in the business world includes products and services purchased and sold ‘on cred- it’ or ‘on account’. Show students the effect of this accrual by having them prepare an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows. Students will often stumble on the concept of Unearned Revenue, thinking that it’s actually a revenue account when in fact it’s a liability. Explain how customer payments that are received before goods or services are provided must be refunded to the customer if those promised goods or services are never actually delivered. Similarly, show students the effect of interest on the financial statements without mixing interest computations into the example. Students frequently get so lost in the computations they overlook the financial statement impact of interest. Initially provide students with the amount of interest, freeing them to focus on its effects. Once students understand how accrued interest affects the financial statements, then cover the mechanics of interest computations. Encourage students to record transactions using the horizontal financial statements model, even when problems do not require them to do so. Developing the habit of recording transactions using the model will help students see the impact of each transaction on the financial statements as well as help students identify their errors if the accounting equation is not in balance. Specific examples are provided in the detailed les- son plan outline. If you would like to begin the chapter with a problem-based learning exercise, see the notes below.

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Chapter 02 - Accounting for Accruals and Deferrals

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Problem-Based Learning Case: Accrual Accounting

(We describe problem-based learning in the introduction to this manual.)

Instructions: The case appears on the following page in a format you can copy or dis- play. Distribute copies of the case to the class before explaining accrual accounting. Ask students to individually develop answers. After allowing students time to develop their individual answers, put them into groups to reach consensus on an answer. Also, ask each group to select a spokesperson. Allow groups time to develop answers, and then call on some of the spokespersons to share their solutions. As you respond to the student solutions, explain the basic concepts of accrual accounting with respect to revenues earned and expenses incurred on account.

The final result is:

Net income: revenue of $145,000 less expenses of $80,000 = $65,000.

Total assets: cash, $45,000 plus accounts receivable, $25,000 = $70,000.

Total liabilities: salaries payable: $5,000.

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Chapter 2 Problem-Based Learning Case: Accrual Accounting

Professional Headhunters, Inc. (PHI), a job placement company, operates in the northeastern United States. During 2012 the company earned $145,000 in revenue by providing services to customers. However, it collected only $120,000 of the revenue in cash. PHI expected to collect the remaining $25,000 in 2013.In addition, PHI incurred $80,000 of expenses. However, by the end of 2012, PHI had paid only $75,000 of the cash owed for ex- penses because it had not yet paid $5,000 to employees who had worked during 2012 but not been paid by the end of the year. PHI expected to pay the $5,000 in cash to the employees during 2013. Based on this information alone, determine the amount of net income, total assets, and total liabilities PHI should report on its 2012 financial statements.

Chapter 02 - Accounting for Accruals and Deferrals

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Detailed Outline of a Lesson Plan for Chapter 2

• Distribute copies of Demonstration Problem 2-1, found near the back of this

chapter of the Instructor’s Manual.

• Explain the phrase “on account.” Tell students this means Packard recogniz-

es the revenue when it is earned, which may be before it collects the cash.Packard’s customers created charge accounts and purchased goods or services by charging the purchases to their accounts. Revenue is recognized in the ac- counting period in which the services are provided regardless of when cash changes hands. This discussion should lead to defining the term accrual. In general, transactions in which a revenue or expense is recognized before cash changes hands are called accruals. Demonstrate this point by recording the revenue recognition for Packard using the horizontal financial statements model. Next, have your students prepare an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows. To mini- mize the time required to prepare these financial statements, you may provide students with copies of the workpaper for Demonstration Problem 2-1. The workpaper is near the back of this chapter of the Instructor’s Manual.

• Since Packard did not issue any stock, the statement of changes in stockhold-

ers’ equity becomes a statement of retained earnings. Although the text does not cover a statement of retained earnings, students should be able to infer the format from their experience with the statement of changes in stockholders’ equity. Use the exercise to discuss diversity in reporting practice. Although there is general consistency in financial reporting, there is also variety. Stu- dents should learn to understand different reporting formats.

• After accounting for the 2012 revenue, assume Packard collects the $5,000

account receivable in 2013. This is the only 2013 transaction. Have students record the event using the horizontal financial statements model and prepare the four basic financial statements for the 2013 accounting period. Encourage students to analyze the difference between the amount of net income and the amount of cash flow from operating activities. This single transaction clearly illustrates differences between the income statement and the statement of cash flows.