Accruals and Deferrals
In order for revenues and expenses to be reported in the time period in which they are earned or incurred, adjusting entries must be made at the end of the accounting period. Adjusting entries are made so the revenue recognition and matching principles are followed.
This lesson completes the treatment of the accounting cycle for service type businesses. It focuses on the year-end activities culminating in the annual report. These include the preparation of adjusting entries, preparing the financial statements themselves, drafting the footnotes to the statements, closing the accounts, and preparing for the audit.
Four Types of Adjusting Entries
- converting assets to expenses
- converting liabilities to revenue
- accruing unpaid expenses
- accruing uncollected revenues
Accounting systems are designed to handle a large number of routine transactions during the year very efficiently, usually with the aid of computers and devices like scanning cash registers, bar code inventory management systems and automatic credit card processing systems. The accounting system has the built-in capability to handle these items with little human intervention, creating appropriate journal entries, and posting thousands of transactions with little effort.
However, at the end of the year accountants must step in and prepare financial statements from all the information that has been collected throughout the year. An accounting system is designed to efficiently capture a large number of transactions. But this information is only partially in accordance to GAAP. The information needs a small amount of adjustment at the end of the year to bring the financial statements in alignment with the requirements of GAAP. And this is where adjusting entries come in.
GAAP also requires certain additional information, referred to as Notes to the Financial Statement. This is a combination of narrative and numerical information that must be prepared by a real live human. Computers can do many things, but the process of preparing financial statements requires professional judgment.
Revenue and Expense
As with everything else in accounting, the terms revenue and expense have definitions. They are not difficult so define, but professional judgment is required to apply the definitions correctly, and in conformity with GAAP. You need to develop a working definition for both terms.
According to FASB in SFAC No. 3, “revenue is derived from delivering or producing goods, rendering services, or other major activities of the firm.” In his book Accounting Theory, (fourth edition, Irwin), Eldon S. Hendriksen comments,
“Revenue is best measured by the exchange value of the product or service of the enterprise….we still have the problem of deciding the point or points in time when we should measure and report the revenue….[I am] in general agreement with [the] view that revenue should be acknowledged and reported at the time of the accomplishment of the major economic activity if its measurement is verifiable and free from bias.
The term revenue realization is used in a technical sense by accountants to establish specific rules for the timing of reporting revenue under circumstances where no single solution is necessarily superior to others in the above context of revenue…..The general view is that realization represents the reporting of revenue when an exchange or severance has occurred. That is, goods or services must have been transferred to a customer or client, giving rise to either the receipt of cash or a claim to cash or other assets [accounts or notes receivable]…. Thus, the term realization has come generally to mean the reporting of revenue when it has been validated by sale.”
There might be other times revenue will be recorded and reported, not related to making a sale. For instance, long term construction projects are reported on the percentage of completion basis. But under most circumstances, revenue will be recorded and reported after a sale is complete, and the customer has received the goods or services.
According to Hendriksen, “…expenses are the using or consuming of goods and services in the process of obtaining revenues…. Frequently, expenses are defined in terms of cost expirations or cost allocations…be careful to distinguish between the measurement of an expense based on cost and the definition of an expense as an activity or process. Emphasis on the latter has the advantage of leaving the measurement of expense open for further discussion.”
At the end of the year, or any time before financial statements are prepared, accountants have to make certain adjustments to the books to make sure that all revenues and expenses are correctly recorded and reported. This is where adjusting entries, accruals and deferrals, come in. Some companies make adjusting entries monthly, in preparation of monthly financial statements.
Accruals
Conditions are satisfied to record a revenue or expense, but money has not changed hands yet. Examples:
Accounts Receivable: work done or goods sold but the customer has not yet paid us.
Accounts Payable: expenses incurred but we have not yet paid the supplier.
These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred.
Example – Accrued Revenue (accounts receivable)
ComputerRx repairs computers. During March they fixed a computer, but the customer not picked it up or paid by the end of the month. The total value of the work done was $200, including parts, labor, etc.
The company should record both revenue and accounts receivable for $200 each. The work was done by the end of the month. Repair technicians were paid for their time and labor. Parts used in the repairs were also paid for. The company should record both the revenue and related expenses.
General Journal
| Date | Account | Debit | Credit |
| Mar-31 | Accounts Receivable | $200 | |
| Computer Repair Revenue | $200 | ||
| To accrue revenue from repairs made during the month. |
The following month when the customer picks up the computer and pays for it, the company will record the receipt of payment as follows.
| Date | Account | Debit | Credit |
| Apr-15 | Cash | $200 | |
| Accounts Receivable | $200 | ||
| To record receipt of payments on account. |
This is a generalized example of a journal entry. Many companies use an accounts receivable subsidiary ledger to keep track of each individual customer.
Example – Accrued Expense (accounts payable)
ComputerRx installs computer networks. They often hire an independent contractor to run cables for the network. They are billed twice a month at a rate of $1.50 per foot of installed cable, including parts and labor. At the end of the month they estimate the contractor installed 500 feet of cable that they had not been billed for.
The company should record an accounts payable for $750 ($1.50 x 500 ft).
General Journal
| Date | Account | Debit | Credit |
| Mar-31 | Installation Expense | $750 | |
| Accounts Payable | $750 | ||
| To accrue installation expense at end of month. |
The following month when the company pays the installer, they will record the payment, as follows.
| Date | Account | Debit | Credit |
| Apr-10 | Accounts Payable | $750 | |
| Cash | $750 | ||
| To record payment on account. |
Note, in both examples above, the revenue or expense is recorded only once, and in the correct month. The second journal entry reflects the receipt or payment of cash to clear the account receivable or payable.
Deferrals
Money has changed hands, but conditions are not yet satisfied to record a revenue or expense.
Prepaid Expenses: insurance, rent, advertising paid in advance but the expense shows up on future income statements.
Unearned Revenue: subscriptions, maintenance contracts paid in advance but the revenue shows up on future income statements.
These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred. Let’s look at a time line and see how it works.
Deferrals are often referred to as allocations. Costs are spread over a number of months using a reasonable method of allocation. In the example below, we use the straight line method – an equal amount is allocated to each month. Other reasonable methods can be used as well.
Example – Deferred Expense
The company has an option of paying its insurance policy once per year, twice a year (2 installments) or monthly (12 installments). They decide to pay it twice a year, in January and July. To get a proper matching of expense to the period we spread each 6-month payment equally over the period the insurance policy covers. The effect of this is to match the appropriate expense with the month it relates to.
| Date | Account | Debit | Credit |
| Jan-2 | Prepaid Insurance | $600 | |
| Cash | $600 | ||
| To record payment of 6 months insurance policy |
Money is spent only once each 6 months, but the expense is allocated to each month by enter an adjusting journal entry in the books. Here’s how the first journal entry would look.
General Journal
| Date | Account | Debit | Credit |
| Jan-2 | Prepaid Insurance | $600 | |
| Cash | $600 | ||
| To record payment of 6 months insurance policy |
And the entry to record January insurance expense at the end of the month.
| Date | Account | Debit | Credit |
| Jan-31 | Insurance Expense | $100 | |
| Prepaid Insurance | $100 | ||
| To record one month insurance policy |
And finally, the Ledger accounts.
General Ledger
Prepaid Insurance
| Date | Description | Debit | Credit | Balance |
| Jan-2 | $600 | $600 | ||
| Jan-31 | $100 | $500 | ||
Prepaid Insurance declines each month as the expense is transferred from the Balance Sheet to the Income Statement.
Insurance Expense
| Date | Description | Debit | Credit | Balance |
| Jan-31 | $100 | $100 | ||
Example – Deferred Revenue
American Artist sells subscriptions to their magazine, published 12 times a year. A subscription costs $36 per year. People can subscribe at any time during the year. They record unearned subscription revenue when payment is received for a subscription.
General Journal
| Date | Account | Debit | Credit |
| Apr-2 | Cash | $36 | |
| Unearned Subscription revenue | $36 | ||
| To record 1 year subscription received |
Each month, as issues of the magazine are mailed, the company recognizes subscription revenue. How do they calculate their total subscription revenue? Each subscription earns them $3 per month ($36/12 issues). Last month they mailed out 3000 copies of the magazine. They will recognize $9,000 in subscription revenue ($3 x 3000 copies).
General Journal
| Date | Account | Debit | Credit |
| Apr-30 | Unearned Subscription revenue | $9,000 | |
| Subscription revenue | $9,000 | ||
| To record 1 year subscription received |
In both examples above, the company is transferring a deferred cost or revenue from the balance sheet to the income statement. We call this articulation.
Depreciation
Depreciation is an example of a deferred expense. In this case the cost is deferred over a number of years, rather than a number of months, as in the insurance example above.
In 2000 the company buys a delivery truck for 12,000. They expect the truck to last 5 years. They decide to use the straight line method, with a salvage value (SV) of $2,000. The depreciable value is $10,000 ($12,000 cost – $2,000 SV). The annual depreciation expense is $2,000 ($10,000/ 5 years).
| Year> |
2001
|
2002
|
2003
|
2004
|
2005
|
Total
|
| $ spent> |
$12,000
|
$0
|
$0
|
$0
|
$0
|
$12,000
|
| Expense taken |
$2,000
|
$2,000
|
$2,000
|
$2,000
|
$2,000
|
$10,000
|
| Salvage Value |
$2,000
|
At the end of 5 years, the company has expensed $10,000 of the total cost. The $2,000 salvage value remains on the books.
General Journal
| Date | Account | Debit | Credit |
| Jan-2 | Delivery Trucks | $12,000 | |
| Cash | $12,000 | ||
| To record purchase of delivery truck | |||
| Dec-31 | Depreciation Expense | $2,000 | |
| Accumulated Depreciation | $2,000 | ||
| To record depreciation expense for the year | |||
The straight line method is only one method used to calculate depreciation. The subject will be covered more in the lesson on fixed assets and depreciation.
General Ledger
Delivery Trucks
| Date | Description | Debit | Credit | Balance |
| 2001 | To record purchase of truck | $12,000 | $12,000 | |
Acculumated Depreciation
| Date | Description | Debit | Credit | Balance |
| 2001 | To record annual depreciation | $2,000 | $2,000 | |
| 2002 | To record annual depreciation | $2,000 | $4,000 | |
| 2003 | To record annual depreciation | $2,000 | $6,000 | |
| 2004 | To record annual depreciation | $2,000 | $8,000 | |
| 2005 | To record annual depreciation | $2,000 | $10,000 |
Book Value & Salvage Value
Book value is the difference between the cost of an asset, and the related accumulated depreciation for that asset.
Book Value = Cost – Accumulated Depreciation
Book Value = ($12,000 – $10,000) = $2,000
The company will stop depreciating the truck after the end of the fifth year. The truck cost $12,000, but only $10,000 in depreciation expense was taken. The remaining book value is equivalent to the salvage value established when the vehicle was purchased. Book value will be used to calculate any gain or loss when the truck is sold or traded.