1. Chapter 3: Accruals and Deferrals
Agenda
Accrual Accounting
Accrued Revenue
Accrued Expenses
Deferred Revenue
Deferred Expenses

2. Agenda
Accrual Accounting

3. 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.

4. 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

5. Examples of Accrual Events
Prepaid Rent / Insurance
Supplies
Deprecations
Unearned Revenue

6. 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.

7. 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

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

9. Agenda
Accrued Revenue

10. 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.

11. 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

12. 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.

13. 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.

14. 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.

15. 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.

16. Accruing Interest Revenue
Assets = Liab Cont. Cap Retained Earnings
+1 interest interest receivable revenue
Income Statement:
Statement of Changes in Equity:
Statement of Cash Flows:
Increases income
Increases equity
No effect on cash flow

17. Agenda
Accrued Expenses

18. 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.

19. 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.

20. 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?

21. 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

22. (5,000) cash (2000) salaries (3000) salary
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

23. 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??

24. Agenda
Deferred Revenue

25. 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 2

26. 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.

27. 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.)

28. 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

29. 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

30. Agenda
Deferred Expenses

31. Deferred Expenses You’ve paid the cash “up-front” but you haven’t
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

32. 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

33. 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.

34. 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

35. 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:
Statement of Changes in Equity:
Statement of Cash Flows:
Decreases income
Decreases equity
No effect on cash flow

36. 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.

37. 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

38. Assets = Liab. + Cont. Cap. + Retained Earnings
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:
Statement of Changes in Equity:
Statement of Cash Flows:
Decreases income
Decreases equity
No effect on cash flow

39. 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.

40. 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

41. 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

42. 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.

43. 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.

44. 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? 6

45. 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

46. 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.

47. 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

48. 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.