Chapter 3: Accruals and Deferrals

Agenda

Accrual Accounting
Accrued Revenue
Accrued Expenses
Deferred Revenue
Deferred Expenses

Agenda

Accrual Accounting

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.

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

Examples of Accrual Events

Prepaid Rent / Insurance
Supplies
Deprecations
Unearned Revenue

Accounts Receivable:
Amounts 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.

Accounts Payable:
Amounts 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

Accruals that need to be made before the

financial statements are prepared
--adjustments to the books
1.

2.

3.

4.

Any revenue earned that has not been billed (no

receivable has been recorded)
Any interest revenue that has been earned on
investments that has not been recorded
Any expense that has been incurred (used) but has
not been recorded (a common one is salary
expense)
Income tax expense incurred but not recorded

Agenda

Accrued Revenue

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.

Accruing Revenue

Accruing revenue affects the accounting

equation in the following way:

Assets
+ A/R

Liab. + Cont. Cap. + Retained Earnings

+ Revenue
Increases income

Income Statement:
Increases equity
Statement of Changes in Equity:
No effect on cash flows
Statement of Cash Flows:

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.

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.

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.

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.

Accruing Interest Revenue

Assets

Liab. + Cont. Cap. + Retained Earnings

+1 interest
receivable

+1 interest
revenue

Income Statement: Increases income

Statement of Changes in Equity: Increases equity
Statement of Cash Flows: No effect on cash flow

Agenda

Accrued Expenses

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.

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.

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?

Accruing Salary Expense

Assets

Liab. + Cont. Cap. + Retained Earnings

+ 2,000 salaries
payable

(2,000) salary
expense
Decreases income

Income Statement (Jan.):

Decreases equity
Statement of Changes in Equity:
No effect on cash flows
Statement of Cash Flows:

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
payable

(3000) salary
expense

Income Statement (for Feb!): Decreases income

Statement of Changes in Equity: Decreases equity
Statement of Cash Flows: Operating cash outflow

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??

Agenda

Deferred Revenue

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

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.

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.)

How does receiving a payment in advance

affect the accounting equation?
Cont. Cap. + Retained Earnings

Assets =

Liab. +

+ cash

+ unearned
revenue

Income Statement: No effect

Statement of Changes in Equity: No effect
Operating cash flows
Statement of Cash Flows:

What happens when the service is finally

performed or the goods are delivered?
Assets =

Liab. +

Cont. Cap. + Retained Earnings

- unearned
revenue

+ service revenue

Income Statement: Increases income

Statement of Changes in Equity: Increases equity
No effect on cash flows
Statement of Cash Flows:

Agenda

Deferred Expenses

Deferred Expenses

Youve paid the cash up-front but you havent

received the goods or services yet.
Prepaid Expenses
Rent
Insurance
Supplies

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Remember: DEFER
means to postpone.
Here, we postpone
recognizing the expense
until we actually use the
goods or services.

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

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.

How does paying the rent in advance

affect the accounting equation?
Assets =

Liab. +

Cont. Cap. + Retained Earnings

+ prepaid rent
- cash
Income Statement:

No effect

Statement of Changes in Equity:

No effect

Statement of Cash Flows: Operating Cash Outflows

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. +
- Prepaid rent
Income Statement:

Cont. Cap. + Retained Earnings

- rent expense
Decreases income

Statement of Changes in Equity: Decreases equity

No effect on cash flow
Statement of Cash Flows:

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.

How does paying for the insurance in

advance affect the accounting equation?
Assets =
Liab. + Cont. Cap. + Retained Earnings
+ prepaid insurance
- cash
Income Statement:

No effect

Statement of Changes in Equity: No effect

Operating cash outflow
Statement of Cash Flows:

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:

Decreases income

Statement of Changes in Equity: Decreases equity

No effect on cash flow
Statement of Cash Flows:

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.

How does buying the supplies in advance

affect the accounting equation?
Assets =
+ supplies
- cash

Liab. + Cont. Cap. + Retained Earnings

Income Statement:

No effect

Statement of Changes in Equity: No effect

Operating cash outflow
Statement of Cash Flows:

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:

Decreases income

Statement of Changes in Equity: Decreases equity

No effect on cash flow
Statement of Cash Flows:

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.

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.

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?

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

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.

Use of the asset:

How does it affect the financial statements?
Assets

Liabilities + CC +

(1,000)
reduces the asset
Income Statement:

RE

(1,000)
expense
Reduces income

Statement of Changes in Equity: Reduces equity

No effect on cash flow
Statement of Cash Flows:

Use of the asset:

How does it affect the financial statements?
Each year for five years, we will reduce the
value on the balance sheet by $1,000.

assets

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.