Accruals

Accruals and
Deferrals:
Timing is Everything in
Accounting

Khalid aziz**2010
1

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Khalid aziz**2010
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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 INVOICE
expenses?
 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. 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

Khalid aziz**2010
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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 record-
keeping 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
 Statement of Changes in Equity: Increases 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.

Khalid aziz**2010
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Interest Revenue

 You have a 6-month, Rs100 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.

Khalid aziz**2010
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Accruing Interest Revenue

 Interest = principal x rate x time
 Interest = Rs100 x .12 x 1/12 =
Rs1
 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 Rs1. Show
how that keeps the accounting
equation in balance.

Khalid aziz**2010
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Accruing Interest Revenue


+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

Khalid aziz**2010
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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.

Khalid aziz**2010
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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.

Khalid aziz**2010
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 Suppose a week’s payroll is Rs5,000.
 On January 31, the company should accrue
Rs2,000 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?

Khalid aziz**2010
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+ 2,000 salaries (2,000) salary
payable expense

 Income Statement (Jan.):
Decreases income
 Statement of Changes in Equity:
Decreases equity
 Statement of Cash Flows:
No effect on cash flows

Khalid aziz**2010
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What happens when the salaries are
actually paid to the employees on
Friday, February 3?

(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

Khalid aziz**2010
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4. 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??

Khalid aziz**2010
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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

Khalid aziz**2010
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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.

Khalid aziz**2010
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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.)

Khalid aziz**2010
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How does receiving a payment in
advance affect the accounting equation?

+ cash + unearned
revenue

Income Statement: No effect

Statement of Changes in Equity: No effect

Statement of Cash Flows: Operating cash flows

Khalid aziz**2010
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What happens when the service is finally
performed or the goods are delivered?

+ cash - unearned
revenue

Income Statement: Increases income

Statement of Changes in Equity: Increases equity

Statement of Cash Flows: No effect on cash flows

Khalid aziz**2010
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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.

Khalid aziz**2010
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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

Khalid aziz**2010
30

JOIN KHALID AZIZ

 ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS,
B.COM.

 CONTACT:
 0322-3385752
 0312-2302870
 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,
KARACHI, PAKISTAN.

Khalid aziz**2010
31

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.

Khalid aziz**2010
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How does paying the rent in advance
affect the accounting equation?

+ prepaid rent
+ cash

Income Statement: Decreases income

Statement of Changes in Equity: Decreases equity

Statement of Cash Flows: Operating Cash Outflows

Khalid aziz**2010
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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.

- Prepaid rent - rent expense




Khalid aziz**2010
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PREPAID INSURANCE

 Often companies pay insurance in
advance.
 When the cash is paid, the company has
purchased an asset called prepaid
insurance.
 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?

+ prepaid insurance
- cash



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.

- prepaid - insurance expense
insurance




Khalid aziz**2010
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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).
 What’s the action that triggers
recognition of the expense?
Actually using the supplies.
Khalid aziz**2010
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How does buying the supplies in advance
affect the accounting equation?

+ supplies
- cash



Statement of Cash Flows: Operating cash outflow

Khalid aziz**2010
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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.

- supplies - supplies expense




Khalid aziz**2010
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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.

Khalid aziz**2010
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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.

Khalid aziz**2010
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Example of Depreciation
 ABC Co. bought a
satellite dish for
Rs5,000. 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?
Khalid aziz**2010
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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: Rs5,000
investing activity cash outflow

Khalid aziz**2010
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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: Rs5,000/5 = Rs1,000 each year.

Khalid aziz**2010
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Use of the asset:

Assets = Liabilities + CC + RE
(1,000) (1,000)
reduces the asset expense

Income Statement: Reduces income

Statement of Changes in Equity: Reduces equity


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Use of the asset:

 Each year for five years, we will reduce the
asset’s value on the balance sheet by Rs1,000.
 Each year for five years, we will have an expense
of Rs1,000 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.

Khalid aziz**2010
47

JOIN KHALID AZIZ

 ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS,
B.COM.

 CONTACT:
 0322-3385752
 0312-2302870
 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,
KARACHI, PAKISTAN.aziz**2010
Khalid
48

Accruals

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Accruals