Chapter 3: Accruals and Deferrals

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Chapter 3 Accruals and Deferrals

• Agenda
• Accrual Accounting
• Accrued Revenue
• Accrued Expenses
• Deferred Revenue
• Deferred Expenses

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Agenda

• Accrual Accounting

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More About Accruals

• 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.
• The economic substance of the transaction
  signals the recordingnot disbursing or receiving
  cash.

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Examples of Accrual Events

• Sales made on account
• Purchases made on credit
• Wages expense for employees
• when theyve worked but you havent 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 havent yet paid the IRS

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Examples of Accrual Events

• Prepaid Rent / Insurance
• Supplies
• Deprecations
• Unearned Revenue

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Accounts ReceivableAmounts owed by customers
for goods and services received

• Recognition of event versus realization of cash
• recognizing a revenue or expense means to record
  it in the accounting records so that it shows up
  on the income statement
• When is revenue recognized?
• when the amounts are earned (required activities
  are complete)
• Realization means you actually get the cash.

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Accounts PayableAmounts you owe creditors for
the purchase of goods and services

• When are costs recognized as expenses?
• when the matching revenue is recognized, or
• when the benefits of the expenditures are received

INVOICE
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Accruals that need to be made before the
financial statements are prepared --adjustments
to the books

1. Any revenue earned that has not been billed (no
   receivable has been recorded)
2. Any interest revenue that has been earned on
   investments that has not been recorded
3. Any expense that has been incurred (used) but has
   not been recorded (a common one is salary
   expense)
4. Income tax expense incurred but not recorded

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Agenda

• Accrued Revenue

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Example 1. Revenue to be accrued

• An employee of Maids-R-Us finished cleaning a
  house on January 31, but didnt get the paperwork
  into the office in time to get it included in the
  January records.
• An income statement for January must include the
  revenue because it has been earned.

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Accruing Revenue

• Accruing revenue affects the accounting equation
  in the following way

• Assets Liab. Cont. Cap.
  Retained Earnings
• A/R Revenue
• Income Statement
• Statement of Changes in Equity
• Statement of Cash Flows

Increases income
Increases equity
No effect on cash flows
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What happens when the customer pays?

• When the customer pays, the accounting equation
  is affected on the asset side only.
• A/R is decreased by the amount of the payment
• Cash is increased by the amount of the payment
• The revenue has already been recognized.

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2. Accruing Interest (Revenue or expense)

• The most common accrual is for interest--the cost
  of borrowing money.
• If you loaned the money or purchased a CD, youd
  be dealing with interest revenue.
• If you borrowed the money, youd be dealing with
  interest expense.

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Interest Revenue

• You have a 6-month, 100 CD that earns 12,
  (always given as an annual rate), purchased on
  January 1.
• The natural recording of this interest revenue
  will happen when you receive the money.
• An income statement for January needs to show the
  amount of interest revenue for January.

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Accruing Interest Revenue

• Interest principal x rate x time
• Interest 100 x .12 x 1/12 1
• Since the rate is per year, the time has to be
  given in terms of a year.
• Interest receivable and interest revenue will
  each be 1. Show how that keeps the accounting
  equation in balance.

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Accruing Interest Revenue

• Assets Liab. Cont. Cap.
  Retained Earnings
• 1 interest 1 interest
  receivable revenue

Income Statement Statement of Changes in
Equity Statement of Cash Flows
Increases income
Increases equity
No effect on cash flow
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Agenda

• Accrued Expenses

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Accrued Salaries

• Salary expense is a common expense that needs to
  be accrued before financial statements are
  prepared.
• Suppose employees work five days per week and are
  paid every Friday, but January 31 falls on a
  Tuesday.
• The salary expense for the week from January 30
  to February 3 will not be paid until Friday,
  February 3.

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Accruing Salary Expense

• The income statement for January should have the
  expense for January 30 and 31, while the February
  income statement will have the expense for
  February 1, 2, and 3.

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Accruing Salary Expense

• Suppose a weeks payroll is 5,000.
• On January 31, the company should accrue 2,000
  worth of salary expense.
• i.e., 2 out of 5 days worth of the salary must
  be a January expense.
• How is this reflected in the accounting equation?

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Accruing Salary Expense

• Assets Liab. Cont. Cap.
  Retained Earnings
• 2,000 salaries (2,000) salary
• payable expense
• Income Statement (Jan.)
• Statement of Changes in Equity
• Statement of Cash Flows

Decreases income
Decreases equity
No effect on cash flows
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What happens when the salaries are actually paid
to the employees on Friday, February 3?

• Assets Liab. Cont. Cap.
  Retained Earnings
• (5,000) cash (2000) salaries (3000)
  salary
• payable expense

• Income Statement (for Feb!)
• Statement of Changes in Equity
• Statement of Cash Flows

Decreases income
Decreases equity
Operating cash outflow
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Taxes to be accrued

• Tax expense is a common expense that needs to be
  accrued when financial statements are prepared.
• The income statement for January needs to include
  the income taxes for January, even though they
  will not be paid until several months later.
• WHY??

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Agenda

• Deferred Revenue

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What is a Deferral?

• A deferral event occurs when cash is received or
  paid before revenue is earned or an expense is
  incurred.
• Deferral events are a part of the accrual basis
  of accounting

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Deferred Revenue

• Youve received payment for something you have
  NOT yet provided.
• Dollars first, action later.
• 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.

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Example of deferred revenue

• A publishing company collects money for magazine
  subscriptions before the magazines are actually
  delivered.
• What is exchanged? Cash is received but the give
  part will come later.
• In the meantime, the company has an obligation--a
  liability. (The company gives a promise of
  future delivery of magazines.)

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How does receiving a payment in advance affect
the accounting equation?

• Assets Liab. Cont. Cap.
  Retained Earnings
• cash unearned
• revenue

Income Statement Statement of Changes in
Equity Statement of Cash Flows
No effect
No effect
Operating cash flows
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What happens when the service is finally
performed or the goods are delivered?
Assets Liab. Cont. Cap.
Retained Earnings - unearned service
revenue revenue
Income Statement Statement of Changes in
Equity Statement of Cash Flows
Increases income
Increases equity
No effect on cash flows
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Agenda

• Deferred Expenses

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Deferred Expenses
Youve paid the cash up-front but you
havent received the goods or services yet.
Remember DEFER means to postpone. Here, we
postpone recognizing the expense until we
actually use the goods or services.
Prepaid Expenses Rent Insurance Supplies
paid in advance
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Deferred Expenses
A special deferral--depreciation
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
Depreciation of plant and equipment
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PREPAID RENT

• Often companies pay rent in advance.
• When the cash is paid, the company has purchased
  an asset called prepaid rent.
• Dollars first--action later.
• Whats the action that triggers recognition of
  the expense?
• Passing of the time to which the rent applies.

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How does paying the rent in advance affect the
accounting equation?
Assets Liab. Cont. Cap.
Retained Earnings prepaid rent - cash
Income Statement Statement of Changes in
Equity Statement of Cash Flows
No effect
No effect
Operating Cash Outflows
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The expense is recorded when the time of the rent
has passed when its been used up.Usually its
an adjustment, made when the financial statements
are being prepared.
Assets Liab. Cont. Cap.
Retained Earnings - Prepaid rent - rent
expense
Income Statement Statement of Changes in
Equity Statement of Cash Flows
Decreases income
Decreases equity
No effect on cash flow
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PREPAID INSURANCE

• Often companies pay insurance in advance.
• When the cash is paid, the company has purchased
  an asset called prepaid insurance.
• Dollars first--action later.
• Whats the action that triggers recognition of
  the expense?
• Passing of the time to which the insurance
  applies.

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How does paying for the insurance in advance
affect the accounting equation?

• Assets Liab. Cont. Cap.
  Retained Earnings
• prepaid insurance
• - cash

Income Statement Statement of Changes in
Equity Statement of Cash Flows
No effect
No effect
Operating cash outflow
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The expense is recorded when the time to which
the insurance applies has passed--when its been
used up. Usually its an adjustment, made when
the financial statements are being prepared.

• Assets Liab. Cont. Cap. Retained
  Earnings
• - prepaid
  - insurance expense
• insurance

Income Statement Statement of Changes in
Equity Statement of Cash Flows
Decreases income
Decreases equity
No effect on cash flow
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BUYING SUPPLIES

• Companies purchase supplies to be used later.
• When the cash is paid, the company has purchased
  an asset called supplies. Sometimes they are
  called supplies-on-hand to differentiate them
  from supplies expense (used).
• Dollars first--action later.
• Whats the action that triggers recognition of
  the expense?
• Actually using the supplies.

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How does buying the supplies in advance affect
the accounting equation?

• Assets Liab. Cont. Cap.
  Retained Earnings
• supplies
• - cash

Income Statement Statement of Changes in
Equity Statement of Cash Flows
No effect
No effect
Operating cash outflow
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The expense is recorded when
supplies are used.
Usually, supplies-on-hand are counted at the end
of the period, and an adjustment is made to get
the amount of the remaining asset correct for the
balance sheet.

• Assets Liab. Cont. Cap. Retained
  Earnings
• - supplies
  - supplies expense

Income Statement Statement of Changes in
Equity Statement of Cash Flows
Decreases income
Decreases equity
No effect on cash flow
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DEPRECIATION

• When a company buys an asset that is used up in
  the business (i.e., they didnt buy it to resell
  it) AND it will be useful for more than one year,
  GAAP says that the expense must be spread over
  the accounting periods during the useful life of
  the asset.

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DEPRECIATION

• The portion of the cost of an asset allocated to
  any one accounting period--
• 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.

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Example of Depreciation

• ABC Co. bought a satellite dish for 5,000. The
  asset is expected to last five years and have no
  salvage value at the end of its useful life. How
  will the purchase and use of the asset affect the
  financial statements?

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Purchase of the asset How does it affect the
financial statements?
Assets Liabilities CC
RE

• 5,000 satellite dish
• (5,000) cash
• Income Statement no effect
• Statement of Changes in Equity no effect
• Statement of Cash Flows 5,000 investing
  activity cash outflow

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USE OF THE ASSET

• We want to allocate the cost of the asset to the
  income statement as an expense during the time
  period we use the asset.
• 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 5,000/5 1,000 each year.

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Use of the asset How does it affect the
financial statements?
Assets Liabilities CC RE

• (1,000) (1,000)
• reduces the asset expense

Income Statement Statement of Changes in
Equity Statement of Cash Flows
Reduces income
Reduces equity
No effect on cash flow
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Use of the asset How does it affect the
financial statements?

• Each year for five years, we will reduce the
  assets value on the balance sheet by 1,000.
• Each year for five years, we will have an expense
  of 1,000 on the income statement.
• Instead of netting out the subtracted amount on
  the balance sheet, we will always show the
  original cost and then the amount of the total
  reduction. That amount is called accumulated
  depreciation and it is a contra-asset.
• The expense is called depreciation expense.