copyright 2003 prentice hall publishing1 chapter 3 accruals and deferrals: timing is everything in...

Copyright 2003 Prentice Hall Publishing

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Chapter 3Chapter 3

Accruals and Deferrals: Accruals and Deferrals: Timing is Everything in AccountingTiming is Everything in Accounting


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More About AccrualsMore 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 recording…not disbursing or receiving cash.


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Examples of Accrual EventsExamples of Accrual Events

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

» when they’ve worked but you haven’t 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 haven’t yet paid the IRS


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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 realization of realization of cashcash recognizing a revenue or expense means to

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

When 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 Payable:Accounts Payable:Amounts you owe creditors Amounts you owe creditors for the purchase of goods and servicesfor 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 Accruals that need to be made before the that need to be made before the financial statements are prepared --financial statements are prepared --adjustments to the “books”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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Revenue Revenue that needs to be accruedthat needs to be accrued

Work that has been completed -- but nothing has been recorded for the financial statements. This situation arises when

a customer has not been billed yet has not paid

Computerization of record-keeping has made this situation less frequent


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

An employee of Maids-R-Us finished cleaning a house on January 31, but didn’t 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 RevenueAccruing 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?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 2. Accruing Interest ((RevenueRevenue or expense) or expense)

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

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

with interest expense.


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Interest RevenueInterest 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 RevenueAccruing 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 RevenueAccruing Interest Revenue


+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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3.3. An Expense to be Accrued An Expense to be Accrued

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 ExpenseAccruing 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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Suppose a week’s 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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+ 2,000 salaries (2,000) salary payable expense

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

Decreases income

Decreases equity



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(5,000) cash (2000) salaries (3000) salary payable 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


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4.4. Taxes to be accrued 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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What is a Deferral?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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DeferredDeferred RevenueRevenue

You’ve 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: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 How does receiving a payment in advance affect the accounting equation? advance affect the accounting equation?


+ cash + unearned revenue

Income Statement:



No effect

No effect

Operating cash flows


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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?


+ cash - unearned revenue

Income Statement:



Increases income

Increases equity



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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.


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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:


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PREPAID RENTPREPAID 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. What’s 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 How does paying the rent in advance affect the accounting equation? affect the accounting equation?


+ prepaid rent

+ cash Income Statement:



Decreases income

Decreases equity

Operating Cash Outflows


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

statements are being prepared.statements are being prepared.


- Prepaid rent - rent expense

Income Statement:



Decreases income

Decreases equity



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PREPAID INSURANCEPREPAID 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. What’s 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 How does paying for the insurance in advance affect the accounting equation? advance affect the accounting equation?

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

Income Statement:



No effect

No effect



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

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

Income Statement:



Decreases income

Decreases equity



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BUYING SUPPLIESBUYING 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. What’s the action that triggers recognition of the

expense?Actually using the supplies.


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

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

Income Statement:



No effect

No effect



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

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

Income Statement:



Decreases income

Decreases equity


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.


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DEPRECIATIONDEPRECIATION

When a company buys an asset that is used up in the business (i.e., they didn’t 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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DEPRECIATIONDEPRECIATION

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 DepreciationExample 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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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) cash

Income Statement: no effect Statement of Changes in Equity: no effect Statement of Cash Flows: $5,000 investing

activity cash outflow

Assets = Liabilities + CC + RE


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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.

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.

USE OF THE ASSETUSE OF THE ASSET


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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)

reduces the asset expense

Assets = Liabilities + CC + RE

Income Statement:



Reduces income

Reduces equity



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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.

copyright 2003 prentice hall publishing1 chapter 3 accruals and deferrals: timing is everything in...

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