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 student 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 subject 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 prod-
ucts and services purchased and sold ‘on credit’ 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. 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 lesson plan outline. If you would like to begin the chapter with a problem-based
learning exercise, see the notes below.
Problem-Based Learning Case: Accrual Accounting
2-3
Chapter 2 Problem-Based Learning Case: Accrual Accounting
Professional Headhunters, Inc. (PHI), a job placement company, oper-
ates in the northeastern United States. During 2014, the company
earned $145,000 in revenue by providing services to customers. How-
ever, it collected only $120,000 of the revenue in cash. PHI expected to
collect the remaining $25,000 in 2015. In addition, PHI incurred $80,000
of expenses. However, by the end of 2014, PHI had paid only $75,000
of the cash owed for expenses because it had not yet paid $5,000 to
employees who had worked during 2014 but had not been paid by the
end of the year. PHI expected to pay the $5,000 in cash to the employ-
ees during 2015. Based on this information alone, determine the
amount of net income, total assets, and total liabilities PHI should re-
port on its 2014 financial statements.
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
2-4
Detailed Outline of a Lesson Plan for Chapter 2
I. Distribute copies of Demonstration Problem 2-1, found near the back of this chapter of
the Instructor’s Manual.
A. Explain the phrase “on account.” Tell students this means Packard recognizes the
revenue when it is earned, which may be before it collects the cash. Packard’s custom-
ers created charge accounts and purchased goods or services by charging the purchases
to their accounts. Revenue is recognized in the accounting 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 minimize 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.
B. Since Packard did not issue any stock, the statement of changes in stockholders’ 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 di-
versity in reporting practice. Although there is general consistency in financial report-
ing, there is also variety. Students should learn to understand different reporting for-
mats.
C. After accounting for the 2014 revenue, assume Packard collects the $5,000 account
receivable in 2015. This is the only 2015 transaction. Have students record the event
using the horizontal financial statements model and prepare the four basic financial
statements for the 2015 accounting period. Encourage students to analyze the differ-
ence 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.
D. Introduce the term unearned revenue before starting part B of this problem. Explain
that unearned revenue is a liability because it represents an obligation to provide fu-
ture services. Make the point that businesses can be obligated to provide services as
well as to pay cash. Show your students how to record the liability using the horizontal
financial statements model.
2-5
E. Explain the year-end adjustment necessary to recognize three months of earned revenue
on December 31. Emphasize the difference between the amount of cash collected and
the amount of revenue recognized. Highlight that Jackson earned and recognized the
revenue after it collected the cash. Draw a general definition of deferrals from this
illustration. Transactions in which a revenue or expense is recognized after cash
changes hands are termed deferrals. Contrast deferrals with accruals which were pre-
sented in part A of Demonstration Problem 2-1. For emphasis, reiterate the explanation
of an accrual. Transactions in which a revenue or expense is recognized before cash
changes hands are termed accruals. Although these are not precise definitions, they
describe the basic concepts in terms students can understand. Explain that accrual ac-
counting uses both accruals and deferrals.
F. Also note the connection between reducing the liability account (unearned revenue)
and recognizing revenue, reinforcing that revenue is an increase in assets or a de-
crease in liabilities from providing services or products to customers. Similarly, an
expense is a decrease in assets or an increase in liabilities that occurs in efforts to
produce revenue. Net income is a change in wealth (increase in net assets). It is not
enough to orally define terms. You must repeatedly demonstrate the definitions within
the context of problems. Gradually, students will understand fundamental accounting
interrelationships.
II. Use separate examples to introduce other types of deferrals (prepaid assets and sup-
plies). You can use exercises 2-8, 2-9 or 2-11 in the textbook as demonstration problems,
or create your own. We often make up demonstration problems like these in the classroom.
Encourage students to think by asking them to attempt to record the effects of events before
you discuss them. For example, instead of defining prepaid assets, simply give the students
an event involving a prepaid asset. Say, “On October 1, 2014, ABC Company paid $1,200
in advance for one year of property insurance protection.” Without having ever discussed
prepaid insurance, ask the students to record the event using the horizontal financial state-
ments model. Make them write down an answer. Don’t be concerned with accuracy. Be
concerned with involvement. Walk around the room and look at what they are doing. Oc-
casionally collect these exercises from the students as in-class assignments. Give them
credit regardless of their answers. The grade is for participation, not accuracy. Your ob-
jective is to motivate them to think about the problem before you offer a solution. At this
stage, you are not evaluating their performance.
III. Time considerations and homework assignments. Completing Demonstration Problems
2-1A & B should require approximately one hour of class time. Have the students work
along with you as you explain the problems. Exercises 2-3, 2-15, 2-16, and 2-17 parallel
the Demonstration Problems and can be considered for homework assignments.
2-6
IV. Use Demonstration Problem 2-2 as a comprehensive summary problem. This is a two-
cycle problem. Explain the first cycle (2014) and then use the second cycle as an in-class
assignment. Allot approximately one hour to complete this assignment. Students needing
additional time can finish the problem as homework. Problem 2-38 mirrors the demonstration
problem and can be used as a homework assignment.
V. Use the horizontal financial statements model to highlight the differences between
accrual and cash basis accounting. For example, suppose a company provides $5,000 of
services on account and later collects $3,000 of the account receivable. The effect of these
two events on the financial statements is shown below.
Event
Balance Sheet
Income Statement
Statement of
No.
Cash
+
Acct. Rec.
=
Liab.
+
Equity
Rev.
─
Exp.
=
Net Inc.
Cash Flows
1
NA
+
5,000
=
NA
+
5,000
5,000
─
n/a
=
5,000
NA
2
3,000
+
(3,000)
=
NA
+
NA
NA
─
n/a
=
NA
+3,000 OA
Include other events you deem appropriate. By this point students have a sufficient back-
ground to use the horizontal financial statements model. It is critically important to estab-
lish a firm foundation in the basics before progressing to more advanced representations.
Introduce the model gradually.
VI. Hand out the official answers to any of the Demonstration Problems that you covered
in class. Doing so allows the students to focus more on understanding the material than
on taking notes for later reference. If they know that they will have access to the official
answers to the problems worked in class, then they will not be as concerned about recording
those answers during the discussion.
2-7
Demonstration Problem 2-1A – Revenue Earned on Account
Part A
Packard Consultants was started in 2014. During that year the company earned $5,000 of con-
sulting revenue on account. Assume this is the only event experienced by Packard during 2014.
Required
1. Record the event using the horizontal financial statements model.
2. Prepare an income statement, a statement of retained earnings, a balance sheet, and a state-
ment of cash flows for 2014.
Part B
During 2015, Packard Consultants collected $5,000 cash from the account receivable it estab-
lished in Part A.
Required
1. Record the event under using the horizontal financial statements model.
2. Prepare an income statement, a statement of retained earnings, a balance sheet, and a state-
ment of cash flows for 2015.
Demonstration Problem 2-1B – Unearned Revenue
Jackson Legal Services was started when a client paid the firm a $12,000 cash retainer on October
1, 2014. Jackson agreed to provide legal advice to the client for a one-year period beginning on
the date of the cash receipt. The closing date for the law practice is December 31.
Required
1. Record the events for 2014 and 2015 using the horizontal financial statements model.
2. Prepare an income statement, a statement of retained earnings, a balance sheet, and a state-
ment of cash flows for 2014 and 2015.
2-8
Demonstration Problem 2-2 – Accruals and Deferrals
Part A Smith Company experienced the following accounting events during 2014:
1. Smith Company was started on January 1 when it issued common stock for $2,000 cash.
2. During the year, the company recognized $1,500 of consulting revenue on account.
3. The company collected $1,200 cash from accounts receivable.
4. Smith accrued salary expense during the year of $900.
5. Paid $700 of the salaries payable liability.
6. Paid dividends of $100 to the stockholders.
7. Paid $360 cash for an insurance policy that covered the company for one year beginning March
1, 2014.
8. On November 1, 2014, Smith collected $2,880 cash in advance for consulting services to be
provided under a one-year contract.
9. Recognized insurance expense (Policy in event 7) for ten months.
10. Recognized income earned under the one-year contract at December 31, 2014.
Part B Smith Company experienced the following accounting events during 2015:
1. Smith Company issued additional common stock for $3,000 cash.
2. During the period, Smith recognized $2,700 of consulting revenue earned on account.
3. Smith collected $2,800 cash from accounts receivable.
4. Smith accrued salary expense of $1,500.
5. The company paid $1,350 of the salaries payable liability.
6. Smith paid dividends of $300 to the stockholders.
7. Paid $420 cash to renew the insurance policy for another one-year term.
8. Smith adjusted the books to reflect the insurance expense that had been incurred in 2015
(described in event 7 of 2014).
9. Smith adjusted the books to reflect the revenue earned in 2015 under the one-year consult-
ing contract that began in 2014 (event 8 in 2014).
Required
1. Record the events using the horizontal financial statements model.
2. For 2014 and 2015, prepare an income statement, a statement of retained earnings, a balance
sheet, and a statement of cash flows.
2-9
Demonstration Problem 2-1A Solution, part 1.
Assets
=
Liabilities
+
Equity
Part A, 2014
Cash
+
Accounts
Receivable
=
Liabilities
+
Common
Stock
+
Retained
Earnings
Beginning balances
$ 0
$ 0
$ 0
$ 0
$ 0
Effect of recognizing revenue
5,000
5,000
Part B, 2015
Effect of collecting cash
5,000
(5,000)
─────
────
────
─────
─────
Ending balances
$5,000
+
$ 0
=
$ 0
+
$ 0
+
$5,000
═════
════
═════
═════
═════
2-10
Demonstration Problem 2-1A Solution, part 2. Financial Statements
Packard Consultants
Income Statements
For the Years Ended December 31,
2014
2015
Consulting revenue
$5,000
$ 0
Expenses
0
0
Net income
$5,000
$ 0
Statements of Retained Earnings
Beginning retained earnings
$ 0
$5,000
Plus: Net income
5,000
0
Less: Dividends
0
0
Ending retained earnings
$5,000
$5,000
Balance Sheets at December 31
Assets
Cash
$ 0
$5,000
Accounts receivable
5,000
0
Total assets
$5,000
$5,000
Equity
Retained earnings
$5,000
$5,000
Statements of Cash Flows
Cash flows from operating activities
$ 0
$5,000
Cash flows from investing activities
0
0
Cash flows from financing activities
0
0
Net change in cash
0
5,000
Beginning cash balance
0
0
Ending cash balance
$ 0
$5,000
2-11
Demonstration Problem 2-1B Solution, part 1.
Assets
=
Liabilities
+
Equity
2014
Cash
=
Unearned
Revenue
+
Com.
Stock
+
Ret. Earn.
Beginning balances
$ 0
$ 0
$ 0
$ 0
1. Recognize liability
12,000
12,000
2. Adjustment for earned revenue
(3,000)
3,000
─────
────
─────
─────
Ending/beginning balances
$12,000
=
$ 9,000
+
$ 0
+
$3,000
2015
1. Adjustment for earned revenue
(9,000)
9,000
─────
────
─────
─────
Ending balances
$12,000
$ 0
$ 0
$12,000
═════
═════
═════
═════