Chapter 3: Accruals and DeferralsChapter 3: Accruals and Deferrals

AgendaAgenda Accrual AccountingAccrual Accounting Accrued RevenueAccrued Revenue Accrued ExpensesAccrued Expenses Deferred RevenueDeferred Revenue Deferred ExpensesDeferred Expenses

AgendaAgenda Accrual AccountingAccrual Accounting

More About AccrualsMore About AccrualsAccrual Accounting: Accrual Accounting: Recording the Recording the financial transactions of a business in the financial transactions of a business in the period in which they occur, rather than in period in which they occur, rather than in the period in which cash is exchanged.the period in which cash is exchanged.

The The economic substanceeconomic substance of the of the transaction signals the recording…not transaction signals the recording…not disbursing or receiving cash.disbursing or receiving cash.

Examples of Accrual EventsExamples of Accrual Events

Sales made “on account”Sales made “on account” Purchases made “on credit”Purchases made “on credit” Wages expense for employeesWages expense for employees

when they’ve worked but you haven’t yet paid when they’ve worked but you haven’t yet paid themthem

Interest on money borrowed or lentInterest on money borrowed or lent when time has passed (so interest has been when time has passed (so interest has been

earned by the lender) but the actual cash for the earned by the lender) but the actual cash for the interest has not changed handsinterest has not changed hands

Income tax expenseIncome tax expense when you owe it but haven’t yet paid the IRSwhen you owe it but haven’t yet paid the IRS

Examples of Accrual EventsExamples of Accrual Events Prepaid Rent / InsurancePrepaid Rent / Insurance SuppliesSupplies DeprecationsDeprecations Unearned RevenueUnearned Revenue

Accounts Receivable:Accounts Receivable:Amounts owed by customers Amounts owed by customers for goods and services receivedfor goods and services received

RecognitionRecognition of event of event versus versus realization of cashrealization of cash recognizing a revenue or expense means recognizing a revenue or expense means

to record it in the accounting records so to record it in the accounting records so that it shows up on thethat it shows up on the income statementincome statement

When When is revenue recognized?is revenue recognized? when the amounts are earned (required when the amounts are earned (required

activities are complete)activities are complete) RealizationRealization means you actually get the cash. means you actually get the cash.

Accounts Payable:Accounts Payable:Amounts you owe creditors Amounts you owe creditors for the purchase of goods and servicesfor the purchase of goods and servicesWhen are costs When are costs recognized recognized as as expensesexpenses?? when the “matching” when the “matching”

revenue is recognized, orrevenue is recognized, or when the benefits of the when the benefits of the

expenditures are expenditures are receivedreceived

INVOICE

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

1.1. Any Any revenuerevenue earned that has not been billed (no earned that has not been billed (no receivable has been recorded)receivable has been recorded)

2.2. Any interest Any interest revenuerevenue that has been earned on that has been earned on investments that has not been recordedinvestments that has not been recorded

3.3. Any Any expenseexpense that has been incurred (used) but that has been incurred (used) but has not been recorded (a common one is salary has not been recorded (a common one is salary expense)expense)

4.4. Income tax Income tax expenseexpense incurred but not recorded incurred but not recorded

AgendaAgenda Accrued RevenueAccrued Revenue

Example:Example: 1.1. Revenue to be accruedRevenue to be accrued

An employee of Maids-R-Us An employee of Maids-R-Us finished cleaning a house on finished cleaning a house on January 31, but didn’t get the January 31, but didn’t get the paperwork into the office in time paperwork into the office in time to get it included in the January to get it included in the January records.records.

An income statement for An income statement for January must include the January must include the revenue because it has been revenue because it has been earned.earned.

Accruing RevenueAccruing Revenue Accruing revenue affects the accounting Accruing revenue affects the accounting

equation in the following way:equation in the following way:Assets =Assets = Liab. + Cont. Cap. + Retained Liab. + Cont. Cap. + Retained

EarningsEarnings

+ A/R+ A/R + Revenue+ Revenue

Income Statement:Income Statement: Statement of Changes in Equity: Statement of Changes in Equity: Statement of Cash Flows:Statement of Cash Flows:

Increases income

Increases equity

No effect on cash flows

What happens when the customer What happens when the customer pays?pays?

When the customer pays, When the customer pays, the accounting equation is the accounting equation is affected on the asset side affected on the asset side only.only. A/R is decreased by the A/R is decreased by the

amount of the paymentamount of the payment Cash is increased by the Cash is increased by the

amount of the paymentamount of the payment The revenue has already The revenue has already

been recognized.been recognized.

2. Accruing Interest 2. Accruing Interest ((RevenueRevenue or expense) or expense)

The most common accrual is for The most common accrual is for interest--the cost of borrowing money. interest--the cost of borrowing money. If you loaned the money or purchased a If you loaned the money or purchased a

CD, you’d be dealing with interest CD, you’d be dealing with interest revenue.revenue.

If you borrowed the money, you’d be If you borrowed the money, you’d be dealing with interest expense.dealing with interest expense.

Interest RevenueInterest Revenue

You have a 6-month, $100 CD that earns 12%, You have a 6-month, $100 CD that earns 12%, (always given as an annual rate),(always given as an annual rate), purchased on purchased on January 1.January 1.

The natural recording of this interest revenue The natural recording of this interest revenue will happen when you receive the money.will happen when you receive the money.

An income statement for January needs to An income statement for January needs to show the amount of interest revenue for show the amount of interest revenue for January.January.

Accruing Interest RevenueAccruing Interest Revenue Interest = principal x rate x timeInterest = principal x rate x time Interest = $100 x .12 x 1/12 = $1Interest = $100 x .12 x 1/12 = $1

Since the rate is “per year,” the Since the rate is “per year,” the time has to be given in terms of a time has to be given in terms of a year.year.

Interest receivable and interest Interest receivable and interest revenue will each be $1. Show how revenue will each be $1. Show how that keeps the accounting equation in that keeps the accounting equation in balance.balance.

Accruing Interest RevenueAccruing Interest Revenue

Assets =Assets = Liab. + Cont. Cap. + Retained Earnings Liab. + Cont. Cap. + Retained Earnings

+1 interest+1 interest +1 interest +1 interest receivablereceivable revenue revenue

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

Increases income

Increases equity

No effect on cash flow

AgendaAgenda Accrued ExpensesAccrued Expenses

Accrued SalariesAccrued Salaries Salary expense is a common expense that needs to Salary expense is a common expense that needs to

be accrued before financial statements are prepared.be accrued before financial statements are prepared.

Suppose employees work five days per week and Suppose employees work five days per week and are paid every Friday, but January 31 falls on a are paid every Friday, but January 31 falls on a Tuesday.Tuesday.

The salary expense for the week from January 30 to The salary expense for the week from January 30 to February 3 will not be paid until Friday, February 3.February 3 will not be paid until Friday, February 3.

Accruing Salary ExpenseAccruing Salary Expense The income The income

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

Accruing Salary ExpenseAccruing Salary Expense

Suppose a week’s payroll is $5,000.Suppose a week’s payroll is $5,000. On January 31, the company should On January 31, the company should

accrue $2,000 worth of salary expense.accrue $2,000 worth of salary expense. i.e., 2 out of 5 days’ worth of the salary i.e., 2 out of 5 days’ worth of the salary

must be a January expense.must be a January expense. How is this reflected in the accounting How is this reflected in the accounting

equation?equation?

Accruing Salary ExpenseAccruing Salary Expense

Assets =Assets = Liab. + Cont. Cap. + Retained Earnings Liab. + Cont. Cap. + Retained Earnings

+ 2,000 salaries+ 2,000 salaries (2,000) salary(2,000) salary payablepayable expense expense

Income Statement (Jan.):Income Statement (Jan.): Statement of Changes in Equity: Statement of Changes in Equity: Statement of Cash Flows:Statement of Cash Flows:

Decreases income

Decreases equity

No effect on cash flows

Assets = Liab. + Cont. Cap. + Retained EarningsAssets = Liab. + Cont. Cap. + Retained Earnings

((5,000) cash (2000) salaries5,000) cash (2000) salaries (3000) salary (3000) salary payablepayable expense expense

What happens when the salaries are What happens when the salaries are actually paid to the employees on actually paid to the employees on Friday, February 3?Friday, February 3?

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

Decreases incomeDecreases equity

Operating cash outflow

Taxes to be accruedTaxes to be accrued

Tax expense is a common expense that Tax expense is a common expense that needs to be accrued when financial needs to be accrued when financial statements are prepared.statements are prepared.

The income statement for January needs The income statement for January needs to include the income taxes for January, to include the income taxes for January, even though they will not be paid until even though they will not be paid until several months later. several months later.

WHY??WHY??

AgendaAgenda Deferred RevenueDeferred Revenue

What is a Deferral?What is a Deferral?

A deferral event occurs when cash A deferral event occurs when cash is received or paid before revenue is received or paid before revenue is earned or an expense is is earned or an expense is incurred.incurred.

Deferral events are a part of the Deferral events are a part of the accrual basis of accountingaccrual basis of accounting

DeferredDeferred RevenueRevenue You’veYou’ve received received payment for something you have payment for something you have

NOT yet provided.NOT yet provided. Dollars first, action later.Dollars first, action later. Revenue is not Revenue is not recognizedrecognized until the service is until the service is

performed or the goods are delivered...but you have performed or the goods are delivered...but you have to to recordrecord the fact that you have received the cash. the fact that you have received the cash.

Example of deferred revenue:Example of deferred revenue:

A publishing company collects money for A publishing company collects money for magazine subscriptions before the magazines are magazine subscriptions before the magazines are actually delivered.actually delivered.

What is exchanged? Cash is received but the What is exchanged? Cash is received but the givegive part will come later. part will come later.

In the meantime, the company has an In the meantime, the company has an obligation--a liability. (The company gives a obligation--a liability. (The company gives a promise of future delivery of magazines.)promise of future delivery of magazines.)

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

Assets = Assets = Liab. + Cont. Cap. + RetainedLiab. + Cont. Cap. + Retained Earnings Earnings+ cash + cash + unearned + unearned

revenuerevenue Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

No effect

No effect

Operating cash flows

What happens when the service is finally What happens when the service is finally performed or the goods are delivered?performed or the goods are delivered?

Assets = Assets = Liab. + Cont. Cap. + RetainedLiab. + Cont. Cap. + Retained Earnings Earnings- unearned - unearned + service revenue+ service revenue revenuerevenue

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

Increases income

Increases equity

No effect on cash flows

AgendaAgenda Deferred ExpensesDeferred Expenses

Deferred ExpensesDeferred Expenses

Prepaid ExpensesRentInsuranceSupplies

You’ve paid the cash “up-front” but you haven’treceived the goods or services yet.

paid in advance

Remember: DEFER means to postpone.

Here, we postpone recognizing the expense until we actually use the goods or services.

Deferred ExpensesDeferred Expenses

Depreciation of plant and equipment

Recognizing an expenditureby spreading it over several years, allocating a part of theexpense to each of several periods during which the assetis used:

A special deferral--depreciation:

PREPAID RENTPREPAID RENT Often companies pay rent in Often companies pay rent in

advance.advance. When the cash is paid, the When the cash is paid, the

company has purchased an asset company has purchased an asset called called prepaid rent.prepaid rent.

Dollars first--action later.Dollars first--action later. What’s the action that triggers What’s the action that triggers

recognition of the expense?recognition of the expense?Passing of the time to which the Passing of the time to which the rent applies.rent applies.

How does paying the rent in advance How does paying the rent in advance affect the accounting equation?affect the accounting equation?

Assets = Assets = Liab. + Cont. Cap. + RetainedLiab. + Cont. Cap. + Retained EarningsEarnings

+ prepaid rent+ prepaid rent- cash - cash Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

No effect

No effect

Operating Cash Outflows

The expense is recorded when the time of the rent has passed – The expense is recorded when the time of the rent has passed – when it’s been used up.when it’s been used up.Usually it’s an adjustment, made when the financial statements are Usually it’s an adjustment, made when the financial statements are

being prepared.being prepared.

Assets = Assets = Liab. + Cont. Cap. + Retained EarningsLiab. + Cont. Cap. + Retained Earnings- Prepaid rent- Prepaid rent - rent expense - rent expense

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

Decreases income

Decreases equity

No effect on cash flow

PREPAID INSURANCEPREPAID INSURANCE Often companies pay insurance in Often companies pay insurance in

advance.advance. When the cash is paid, the company When the cash is paid, the company

has purchased an asset called has purchased an asset called prepaid prepaid insurance.insurance.

Dollars first--action later.Dollars first--action later. What’s the action that triggers What’s the action that triggers

recognition of the expense?recognition of the expense?Passing of the time to which the Passing of the time to which the insurance applies.insurance applies.

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

Assets =Assets = Liab. + Cont. Cap. + Retained Earnings Liab. + Cont. Cap. + Retained Earnings + prepaid insurance+ prepaid insurance - cash- cash

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

No effect

No effect

Operating cash outflow

The expense is recorded when the time to which the The expense is recorded when the time to which the insurance applies has passed--when it’s been used up. insurance applies has passed--when it’s been used up. Usually it’s an adjustment, made when the financial statements are being prepared.

Assets = Liab. + Cont. Cap. + Retained EarningsAssets = Liab. + Cont. Cap. + Retained Earnings- prepaid - prepaid - insurance expense - insurance expenseinsuranceinsurance

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

Decreases income

Decreases equity

No effect on cash flow

BUYING SUPPLIESBUYING SUPPLIES Companies purchase supplies to be Companies purchase supplies to be

used later.used later. When the cash is paid, the company When the cash is paid, the company

has purchased an asset called has purchased an asset called supplies. supplies. Sometimes they are called Sometimes they are called supplies-on-handsupplies-on-hand to differentiate them from supplies expense to differentiate them from supplies expense (used).(used).

Dollars first--action later.Dollars first--action later. What’s the action that triggers What’s the action that triggers

recognition of the expense?recognition of the expense?Actually Actually usingusing the supplies. the supplies.

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

Assets =Assets = Liab. + Cont. Cap. + Retained Earnings Liab. + Cont. Cap. + Retained Earnings + supplies+ supplies - cash- cash

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

No effect

No effect

Operating cash outflow

The expense is recorded when The expense is recorded when supplies are used.supplies are used.

Assets = Liab. + Cont. Cap. + Retained EarningsAssets = Liab. + Cont. Cap. + Retained Earnings- supplies - supplies - supplies expense - supplies expense

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

Decreases income

Decreases equity

No effect on cash flow

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.

DEPRECIATIONDEPRECIATION When a company buys an When a company buys an

asset that is used up in the asset that is used up in the business (i.e., they didn’t business (i.e., they didn’t buy it to resell it) AND it buy it to resell it) AND it will be useful for more will be useful for more than one year, GAAP says than one year, GAAP says that the expense must be that the expense must be spread over the spread over the accounting periods during accounting periods during the useful life of the asset.the useful life of the asset.

DEPRECIATIONDEPRECIATION The portion of the cost of an asset The portion of the cost of an asset

allocated to any one accounting period--allocated to any one accounting period--DEPRECIATION EXPENSEDEPRECIATION EXPENSE

Depreciation of an asset is Depreciation of an asset is an allocation process--spreading an allocation process--spreading the cost of an asset that benefits more the cost of an asset that benefits more than one accounting period over the than one accounting period over the estimated useful life of the asset.estimated useful life of the asset.

Example of DepreciationExample of Depreciation

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

PurchasePurchase of the asset: of the asset: How does it affect the financial statements?How does it affect the financial statements?

+5,000 satellite dish+5,000 satellite dish (5,000) cash(5,000) cash

Income Statement: Income Statement: no effectno effectStatement of Changes in Equity: Statement of Changes in Equity: no no

effecteffectStatement of Cash Flows: Statement of Cash Flows: $5,000 $5,000

investing activity cash outflowinvesting activity cash outflow

Assets = Liabilities + CC + RE

We want to We want to allocateallocate the cost of the asset to the income statement as an the cost of the asset to the income statement as an expense during the time period we use the asset.expense during the time period we use the asset.

If we depreciate the asset using the STRAIGHT LINE method, we will 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 divide the cost of the asset (minus any estimated salvage value) by the useful life: $5,000/5 = $1,000 each year.useful life: $5,000/5 = $1,000 each year.

USE OF THE ASSETUSE OF THE ASSET

UseUse of the asset: of the asset: How does it affect the financial statements?How does it affect the financial statements?

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

Assets = Liabilities + CC + RE

Income Statement:

Statement of Changes in Equity:

Statement of Cash Flows:

Reduces income

Reduces equity

No effect on cash flow

UseUse of the asset: of the asset: How does it affect the financial statements?How does it affect the financial statements?

Each year for five years, we will reduce the asset’s 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.