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

2. 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.

3. 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

4. Copyright 2003 Prentice Hall Publishing4 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

5. Copyright 2003 Prentice Hall Publishing5 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.

6. Copyright 2003 Prentice Hall Publishing6 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 yet been billed.

7. Copyright 2003 Prentice Hall Publishing7 3. An Expense to be Accrued l Salary expense is a common expense that needs to be accrued before financial statements are prepared.

8. Copyright 2003 Prentice Hall Publishing8 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??

9. Copyright 2003 Prentice Hall Publishing9 What is a Deferral? l A deferral event occurs when cash is received or paid before revenue is earned or benefits are used up.

10. Copyright 2003 Prentice Hall Publishing10 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.

11. Copyright 2003 Prentice Hall Publishing11 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.)

12. Copyright 2003 Prentice Hall Publishing12 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.

13. Copyright 2003 Prentice Hall Publishing13 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.

14. Copyright 2003 Prentice Hall Publishing14 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.

15. Copyright 2003 Prentice Hall Publishing15 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.

16. Copyright 2003 Prentice Hall Publishing16 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.

17. Copyright 2003 Prentice Hall Publishing17DEPRECIATION 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.

18. Copyright 2003 Prentice Hall Publishing18 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

19. Copyright 2003 Prentice Hall Publishing19 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.