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 recording…not
disbursing or receiving cash.
 Examples 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
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? INVOICE
 when the “matching”
revenue is recognized, or
 when the benefits of the
expenditures are
received
 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
 Agenda
 Accrued Revenue
Example:
1. 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.
 Accruing Revenue
 Accruing revenue affects the accounting
equation in the following way:
Assets = Liab. + Cont. Cap. + Retained Earnings

+ A/R + Revenue

 Income Statement: Increases income

 Statement of Changes in Equity:
Increases equity

 Statement of Cash Flows: No effect on 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, you’d be dealing with interest
revenue.
If you borrowed the money, you’d 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 +1 interest
receivable 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 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?
 Accruing Salary Expense

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

+ 2,000 salaries (2,000) salary

payable expense

 Income Statement (Jan.): Decreases income

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 (3000) salary

payable 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
 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.
 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?

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

+ cash + unearned
revenue
Income Statement: No effect

Statement of Changes in Equity: No effect

Statement of Cash Flows: Operating cash flows

 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: Increases income

Statement of Changes in Equity: Increases equity

Statement of Cash Flows: No effect on cash flows

Agenda
 Deferred Expenses
Deferred Expenses
You’ve paid the cash “up-front” but you haven’t
received the goods or services yet.
Remember: DEFER
Prepaid Expenses means to postpone.
Rent Here, we postpone
Insurance recognizing the expense
Supplies 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.
 What’s 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 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 rent - rent expense

Income Statement: Decreases income

Statement of Changes in Equity: Decreases equity

Statement of Cash Flows: No effect on cash flow

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.
 What’s 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

Statement of Cash Flows: Operating cash outflow

The expense is recorded when the time to which the
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 Earnings
- prepaid - insurance expense
insurance

Income Statement: Decreases income

Statement of Changes in Equity: Decreases equity

Statement of Cash Flows: No effect on cash flow

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.
 What’s the action that triggers
recognition of the expense?
Actually using the supplies.
 How does buying the supplies in advance
affect the accounting equation?

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

+ supplies
- cash

Income Statement: No effect

Statement of Changes in Equity: No effect

Statement of Cash Flows: Operating cash outflow

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

Statement of Cash Flows: No effect on cash flow

DEPRECIATION
 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.
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 + RE
(1,000) (1,000)
reduces the asset expense
Income Statement: Reduces income

Statement of Changes in Equity: Reduces equity

Statement of Cash Flows: No effect on cash flow

 Use of the asset:
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.