Copyright 2003 Prentice Hall Publishing1 Chapter 3 Accruals and Deferrals: Timing is Everything in Accounting

Copyright 2003 Prentice Hall Publishing2 More About Accruals 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.

Copyright 2003 Prentice Hall Publishing3 Examples of Accrual Events l Sales made “on account” l Purchases made “on credit” l Wages expense for employees »when they’ve worked but you haven’t yet paid them l 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 l Income tax expense »when you owe it but haven’t yet paid the IRS

Copyright 2003 Prentice Hall Publishing4 Accounts Receivable: Amounts owed by customers for goods and services received l Recognition of event realization of cash l Recognition of event versus realization of cash n recognizing a revenue or expense means to record it in the accounting records so that it shows up on the income statement l When l When is revenue recognized? n when the amounts are earned (required activities are complete) l Realization means you actually get the cash.

Copyright 2003 Prentice Hall Publishing5 Accounts Payable: Amounts you owe creditors for the purchase of goods and services When are costs recognized as expenses? n when the “matching” revenue is recognized, or n when the benefits of the expenditures are received INVOICE

Copyright 2003 Prentice Hall Publishing6 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

Copyright 2003 Prentice Hall Publishing7 Revenue that needs to be accrued l Work that has been completed -- but nothing has been recorded for the financial statements. n This situation arises when a customer has not been billed yet has not paid n Computerization of record- keeping has made this situation less frequent

Copyright 2003 Prentice Hall Publishing8 Example: 1. Revenue to be accrued l 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. l An income statement for January must include the revenue because it has been earned.

Copyright 2003 Prentice Hall Publishing9 Accruing Revenue l Accruing revenue affects the accounting equation in the following way: Assets = Liab. + Cont. Cap. + Retained Earnings + A/R+ Revenue l Income Statement: l Statement of Changes in Equity: l Statement of Cash Flows: Increases income Increases equity No effect on cash flows

Copyright 2003 Prentice Hall Publishing10 What happens when the customer pays? l When the customer pays, the accounting equation is affected on the asset side only. n A/R is decreased by the amount of the payment n Cash is increased by the amount of the payment l The revenue has already been recognized.

Copyright 2003 Prentice Hall Publishing11 2. Accruing Interest (Revenue or expense) 2. Accruing Interest (Revenue or expense) l The most common accrual is for interest-- the cost of borrowing money. n If you loaned the money or purchased a CD, you’d be dealing with interest revenue. n If you borrowed the money, you’d be dealing with interest expense.

Copyright 2003 Prentice Hall Publishing12 Interest Revenue l You have a 6-month, $100 CD that earns 12%, (always given as an annual rate), purchased on January 1. l The natural recording of this interest revenue will happen when you receive the money. l An income statement for January needs to show the amount of interest revenue for January.

Copyright 2003 Prentice Hall Publishing13 Accruing Interest Revenue l Interest = principal x rate x time l Interest = $100 x.12 x 1/12 = $1 n Since the rate is “per year,” the time has to be given in terms of a year. l Interest receivable and interest revenue will each be $1. Show how that keeps the accounting equation in balance.

Copyright 2003 Prentice Hall Publishing14 Accruing Interest Revenue Assets = Liab. + Cont. Cap. + Retained Earnings +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

Copyright 2003 Prentice Hall Publishing15 3. An Expense to be Accrued l Salary expense is a common expense that needs to be accrued before financial statements are prepared. l Suppose employees work five days per week and are paid every Friday, but January 31 falls on a Tuesday. l The salary expense for the week from January 30 to February 3 will not be paid until Friday, February 3.

Copyright 2003 Prentice Hall Publishing16 Accruing Salary Expense l 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.

Copyright 2003 Prentice Hall Publishing17 Accruing Salary Expense l Suppose a week’s payroll is $5,000. l On January 31, the company should accrue $2,000 worth of salary expense. l i.e., 2 out of 5 days’ worth of the salary must be a January expense. l How is this reflected in the accounting equation?

Copyright 2003 Prentice Hall Publishing18 Accruing Salary Expense Assets = Liab. + Cont. Cap. + Retained Earnings + 2,000 salaries(2,000) salary payable expense l Income Statement (Jan.): l Statement of Changes in Equity: l Statement of Cash Flows: Decreases income Decreases equity No effect on cash flows

Copyright 2003 Prentice Hall Publishing19 Assets = Liab. + Cont. Cap. + Retained Earnings (5,000) cash (2000) salaries (3000) salary payable expense What happens when the salaries are actually paid to the employees on Friday, February 3? Income Statement (for Feb!): Statement of Changes in Equity: Statement of Cash Flows: Decreases income Decreases equity Operating cash outflow

Copyright 2003 Prentice Hall Publishing20 4. Taxes to be accrued 4. Taxes to be accrued l Tax expense is a common expense that needs to be accrued when financial statements are prepared. l The income statement for January needs to include the income taxes for January, even though they will not be paid until several months later. l WHY??

Copyright 2003 Prentice Hall Publishing21 What is a Deferral? l A deferral event occurs when cash is received or paid before revenue is earned or an expense is incurred. l Deferral events are a part of the accrual basis of accounting

Copyright 2003 Prentice Hall Publishing22 Deferred Revenue l You’ve received payment for something you have NOT yet provided. l Dollars first, action later. l 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.

Copyright 2003 Prentice Hall Publishing23 Example of deferred revenue: Example of deferred revenue: A publishing company collects money for magazine subscriptions before the magazines are actually delivered. n What is exchanged? Cash is received but the give part will come later. n In the meantime, the company has an obligation--a liability. (The company gives a promise of future delivery of magazines.)

Copyright 2003 Prentice Hall Publishing24 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 Operating cash flows

Copyright 2003 Prentice Hall Publishing25 What happens when the service is finally performed or the goods are delivered? Assets = Liab. + Cont. Cap. + Retained Earnings + cash - unearned revenue Income Statement: Statement of Changes in Equity: Statement of Cash Flows: Increases income Increases equity No effect on cash flows

Copyright 2003 Prentice Hall Publishing26 Deferred Expenses Prepaid Expenses Rent Insurance Supplies You’ve paid the cash “up-front” but you haven’t received 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.

Copyright 2003 Prentice Hall Publishing27 Deferred Expenses Depreciation of plant and equipment 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: A special deferral--depreciation:

Copyright 2003 Prentice Hall Publishing28 PREPAID RENT l Often companies pay rent in advance. l When the cash is paid, the company has purchased an asset called prepaid rent. l Dollars first--action later. l What’s the action that triggers recognition of the expense? Passing of the time to which the rent applies.

Copyright 2003 Prentice Hall Publishing29 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: Decreases income Decreases equity Operating Cash Outflows

Copyright 2003 Prentice Hall Publishing30 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

Copyright 2003 Prentice Hall Publishing31 PREPAID INSURANCE l Often companies pay insurance in advance. l When the cash is paid, the company has purchased an asset called prepaid insurance. l Dollars first--action later. l What’s the action that triggers recognition of the expense? Passing of the time to which the insurance applies.

Copyright 2003 Prentice Hall Publishing32 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 Operating cash outflow

Copyright 2003 Prentice Hall Publishing33 The expense is recorded when the time to which the insurance applies has passed--when it’s been used up. 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

Copyright 2003 Prentice Hall Publishing34 BUYING SUPPLIES l Companies purchase supplies to be used later. l 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). l Dollars first--action later. l What’s the action that triggers recognition of the expense? Actually using the supplies.

Copyright 2003 Prentice Hall Publishing35 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 Operating cash outflow

Copyright 2003 Prentice Hall Publishing36 The expense is recorded when supplies are used. 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 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.

Copyright 2003 Prentice Hall Publishing37 DEPRECIATION l 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.

Copyright 2003 Prentice Hall Publishing38DEPRECIATION l The portion of the cost of an asset allocated to any one accounting period-- DEPRECIATION EXPENSE l 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.

Copyright 2003 Prentice Hall Publishing39 Example of Depreciation l 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?

Copyright 2003 Prentice Hall Publishing40 Purchase of the asset: 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

Copyright 2003 Prentice Hall Publishing41 l We want to allocate the cost of the asset to the income statement as an expense during the time period we use the asset. l 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

Copyright 2003 Prentice Hall Publishing42 Use of the asset: How does it affect the financial statements? (1,000) reduces the asset 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

Copyright 2003 Prentice Hall Publishing43 Use of the asset: How does it affect the financial statements? XEach year for five years, we will reduce the asset’s value on the balance sheet by $1,000. XEach year for five years, we will have an expense of $1,000 on the income statement. XInstead 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. XThe expense is called depreciation expense.