Chapter 3
Accruals and Deferrals:
Timing is Everything in Accounting
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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.
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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
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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.
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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
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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
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Revenue that needs to be accrued

Work that has been
completed -- but nothing
has been recorded for
the financial statements.


This situation arises when
a customer has not been
billed yet has not paid
Computerization of recordkeeping has made this
situation less frequent
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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.
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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
Increases equity
 Statement of Changes in Equity:
 Statement of Cash Flows: No effect on cash flows

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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.
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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.
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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.
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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.
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Accruing Interest Revenue
Assets
=
Liab.
+ Cont. Cap. +
+1 interest
receivable
Retained Earnings
+1 interest
revenue
Income Statement: Increases income
Statement of Changes in Equity: Increases equity
Statement of Cash Flows: No effect on cash flow
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3. An Expense to be Accrued



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.
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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.
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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?
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Accruing Salary Expense
Assets
=
Liab.
+ Cont. Cap. +
Retained Earnings
+ 2,000 salaries
payable
(2,000) salary
expense
Income Statement (Jan.): Decreases income
 Statement of Changes in Equity: Decreases equity
 Statement of Cash Flows: No effect on cash flows

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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
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4. Taxes to be accrued


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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??
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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
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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.
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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.)
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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
Statement of Cash Flows: Operating cash flows
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What happens when the service is finally
performed or the goods are delivered?
Assets =
Liab.
+
+ cash
- unearned
revenue
Cont. Cap. + Retained Earnings
Income Statement: Increases income
Statement of Changes in Equity: Increases equity
Statement of Cash Flows: No effect on cash flows
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Deferred Expenses
You’ve paid the cash “up-front” but you haven’t
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.
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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
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PREPAID RENT

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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.
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How does paying the rent in advance
affect the accounting equation?
Assets =
Liab.
+
Cont. Cap. + Retained Earnings
+ prepaid rent
+ cash
Income Statement:
Decreases income
Statement of Changes in Equity:
Decreases equity
Statement of Cash Flows: Operating Cash Outflows
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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
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PREPAID INSURANCE

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
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.
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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
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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
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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.
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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
Statement of Cash Flows: Operating cash outflow
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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
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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.
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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.
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Example of Depreciation

Copyright 2003
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?
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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
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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.
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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
Statement of Cash Flows: No effect on cash flow
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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.
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