978-0136115274 Chapter 3 Lecture Notes

CHAPTER 3

ACCRUALS AND DEFERRALS: TIMING IS

EVERYTHING IN ACCOUNTING

CHAPTER OVERVIEW

The chapter begins with a discussion of how income (also called net income, net profit, or net

earnings) is measured over a particular period of time (month, quarter, or year). In order to

measure earnings for a period of time, we have to divide revenues and expenses among those

time periods—the most crucial part of accounting. This is made more challenging by the fact that

there are timing differences between the cash exchange and the recognition of revenues and

expenses.

The second part of the chapter discusses accruals. Two specific examples are presented: accrual

of interest expense and accrual of interest revenue (along with an explanation of interest

calculations) and subsequent payment or receipt of the cash. Next, accruals for other types of

revenues and expenses are discussed, including revenue/accounts receivable and salaries

expense/salaries payable.

The third part of the chapter discusses deferrals. First, deferrals related to revenues are presented.

A specific example is provided illustrating the concept of unearned revenue. Next, deferrals

related to expenses are presented, with specific examples and an explanation of the four most

common: insurance, rent, supplies, and equipment. A complete explanation is presented for why

a long-lived asset like equipment or a building is not expensed in the current period, but instead,

is deferred and recognized in later periods as depreciation expense.

The chapter contains a summary problem that continues the Team Shirts example from Chapters

1 and 2 and presents the student with transactions for the third month of business. The student is

shown how to analyze transactions, make adjustments, and prepare the four financial statements

for the business.

The final part of the chapter discusses basic ratio analysis, introducing profit margin on sales.

Next there is a continuing discussion of business risks, specifically highlighting risks associated

with financial information.

Learning Objectives

After completing Chapter 3, your students should be able to answer these questions:

1. Define accrual accounting and explain how income is measured.

2. Explain accruals and how they affect the financial statements; describe and perform

the adjustments related to accruals.

3. Explain deferrals and how they affect the financial statements; describe and perform

the adjustments related to deferrals.

4. Construct the basic financial statements from a given set of transactions that include

accruals and deferrals and recognize the effect of these transactions on actual

financial statements.

5. Compute and explain the profit margin on sales ratio.

6. Explain the business risks associated with financial records and accounting

information.

CHAPTER OUTLINE

Measuring Income (LO 1)

I. At certain points in the life of a company, owners, investors, creditors, and others want to

know the company’s financial position and accomplishments.

a. Main goal of most companies is to make a profit.

b. Net income, net profit, and net earnings all mean the same thing.

c. Net income = revenue – expenses (during a period of time)

II. The continuous life of a business needs to be divided into discrete periods of time:

a. Months

b. Quarters

c. Years

III. Income statement (also called statement of operations or profit and loss statement)

a. The way revenue and expenses are divided among these periods is crucial.

b. Timing differences arise when revenues are earned and collected in different

accounting periods. They also arise when expenses are incurred in one accounting

period and paid for in another.

c. Timing differences must be reflected in the financial statements as accruals and

deferrals.

d. Accruals are transactions in which the revenue has been incurred but no cash has

been exchanged.

e. Deferrals are transactions in which the cash is exchanged before the revenue is

earned or the expense is incurred.

Accruals (LO 2)

I. When the substance of a transaction takes place before any cash changes hands, that

transaction is included in the measurement of income.

a. If revenue is earned, it is included on the income statement.

b. If expenses are incurred, they are included on the income statement.

II. Accrued revenue

a. When you loan money, you receive cash for the use of that money (they are “renting”

the money).

Teaching Tip

Use the example that begins on page 100 to illustrate the effect of these transactions on the

accounting equation.

b. The rent is called interest.

c. Interest is the cost of using someone else’s money.

d. Interest receivable is an asset. It is the amount a company is owed for loaning money

(after the time period to which the interest applies has passed).

e. Passage of time is the action related to interest.

i. The action has occurred (using someone else’s money).

ii. No cash has changed hands (you have not paid the interest yet).

f. An adjustment is necessary to properly state the interest revenue on the income

statement and the interest receivable on the balance sheet.

i. Making the adjustment is called accruing interest.

ii. Interest = Principal x Rate x Time

g. Later, when you receive the interest on the maturity date, no expense is recorded.

i. The revenue was in the previous period.

ii. The payment simply reduces the asset (interest receivable).

h. A company that lends money accrues interest revenue during the time the loan is

outstanding.

i. Realized means the cash is collected. Sometimes revenue is recognized before it is

realized.

III. Accrued expenses

a. When you borrow money, you pay for the use of that money (you are “renting” the

money).

b. The rent you pay is called interest.

c. Interest expense is the cost of using someone else’s money.

d. Interest payable is a liability. It is the amount a company owes for borrowing

money (after the time period to which the interest applies has passed).

e. Passage of time is the action related to interest expense.

i. The action has occurred (using someone else’s money).

ii. No cash has changed hands (you have not paid the interest yet).

f. An adjustment is necessary to properly state the interest expense on the income

statement and the interest payable on the balance sheet.

i. Making the adjustment is called accruing interest.

ii. Interest = Principal x Rate x Time

g. Later, when you pay the interest on the maturity date, no expense is recorded.

i. The expense was in the previous period (when you used the money).

ii. The payment simply reduces the liability (interest payable).

h. One of the most common accruals is salary expense.

i. Typically, a company records salary expense when it pays its employees.

j. At the end of the year, you need to record the salary expense for the work that your

employees have done since the last time you paid them.

k. The accrual will increase salary payable (liability) and decrease retained earnings

(salary expense).

l. When you pay the employees, salary payable will decrease and cash will decrease.

Teaching Tip

Ask the students to think about the last time they received a paycheck. When did they receive it?

When did they earn it? When did they perform the work?

Deferrals (LO 3)

I. The word “defer” means to put off or postpone.

II. In accounting, a deferral refers to a transaction in which the cash exchange takes place

before the economic substance of the transaction.

a. The recognition of the revenue or expense is deferred or postponed.

b. Adjustment is needed as the revenue or expense is recognized.

III. Deferred revenue

a. Receiving cash before the revenue is earned (e.g., money received for subscriptions)

i. Unearned revenue is a liability. It represents the amount of goods or services

that a company owes its customers.

ii. Cash has been collected, but action of earning the revenue has not taken place.

iii. When earnings process takes place, revenue is recorded and unearned revenue

is reduced.

b. Subscriptions

i. When a subscription is sold, the company records unearned revenue.

ii. As the company earns the revenue by sending the magazines, the earned

amounts will be deducted from the liability and recognized as

revenue.

c. Gift cards

i. When you buy a gift card, the company you buy it from records unearned

revenue.

ii. The revenue is recognized as the cards are redeemed or expire.

IV. Deferred expenses

a. Four kinds of expenses are commonly paid in advance:

i. Insurance

ii. Rent

iii. Supplies

iv. Equipment (used in more than one fiscal period)

b. Insurance

i. Company pays for insurance coverage.

ii. Company has a new asset (prepaid insurance).

iii. No expense is incurred at the time of the cash exchange.

iv. The recognition of insurance expense is deferred until it is incurred.

v. As time passes, insurance is used or expires.

vi. Adjustment is required to recognize the insurance expense (portion used) and

reduce prepaid insurance (asset).

Teaching Tip

Use Exhibit 3.6 to illustrate the payment and eventual expensing of insurance.

c. Rent

i. Company pays for rent in advance.

ii. Company has a new asset. Prepaid rent is an asset that represents amounts

paid for rent but not yet used.

iii. No expense is incurred at the time of the cash exchange.

iv. The recognition of rent expense is deferred until it is incurred.

v. As time passes, rent is used or expires.

vi. Adjustment is required to recognize the rent expense (portion used) and

reduce prepaid rent (asset).

d. Supplies

i. Supplies are not called inventory. Supplies are miscellaneous items used in

the business.

ii. Company pays for supplies in advance.

iii. Company has a new asset (supplies).

iv. No expense is incurred at the time of the cash exchange.

v. The recognition of supplies expense is deferred until it is incurred.

vi. As the supplies are used or consumed, the expense is incurred.

vii. Adjustment is required to recognize the supplies expense (portion used) and

reduce supplies (asset).

Teaching Tip

Use Exhibit 3.7 to illustrate the purchase and eventual expensing of supplies.

Teaching Tip

Stone Company had $1,000 of supplies at the beginning of 20X2. Stone Company purchased

$10,000 of supplies on account in 20X2 and paid $8,000 for those supplies by year end. Stone

had $1,500 of supplies left at the end of 20X2. What amount of Supplies Expense should be

recorded for 20X2? The amount of supplies used, $9,500, should be deducted from revenue in

20X2. The amount purchased or paid is not considered an expense under the accrual basis.

e. Equipment

i. When a company purchases an asset that will be used for more than one

accounting period, the amount of the purchase is not an expense when the

asset is purchased.

ii. When the asset is purchased, the company has a new asset.

iii. The expense of using the asset is deferred and recognized during the periods

in which the asset is used to generate revenue.

iv. This is called depreciating an asset – to recognize the cost of the asset as an

expense over more than one period.

v. The initial cost of the asset is spread over its useful life by dividing the

number of periods into the cost of the asset minus the residual value. The

residual value, also known as salvage value, is the estimated value of an asset

at the end of its useful life.

vi. Adjustment is required to recognize the expense allocated to a specific period

(depreciation expense) and reduce the asset (accumulated depreciation – a

contra-asset). A contra-asset is an amount that is deducted from an asset.

vii. Accumulated depreciation is the reduction to the cost of the asset. It is

shown on the balance sheet as a deduction from the asset.

viii. The book value of an asset is the cost minus the accumulated depreciation

related to the asset. Carrying value is another name for book value.

Teaching Tip

“An asset is just an expense waiting to happen.” Try putting that statement on the board or

screen to start the class period where you talk about prepaid expenses. Come back to it after you

are done. See if the students understand what you mean by that statement after you have

explained these types of entries.

Teaching Tip

Students often confuse accumulated depreciation and depreciation expense. Depreciation

Expense is the amount of depreciation recorded for the current period and belongs on the income

statement. Accumulated Depreciation is the sum of all depreciation expense recorded to date and

is deducted from the related asset account on the balance sheet.

Teaching Tip

Use Exhibit 3.9 to illustrate the purchase and eventual expensing of a long-lived asset.

Effects of Accruals and Deferrals on Financial Statements (LO 4)

I. The summary problem uses the Team Shirts example developed in Chapters 1 and 2.

II. Transactions for the business’s third month of business (March) are introduced.

III. The students are shown the necessary adjustments for accruals and deferrals and financial

statements for the month of March.

a. Adjustment 1 – Depreciation

i. This is a cash exchange that took place on March 1.

ii. The expense was deferred until incurred (computer was used).

iii. The adjustment involves recognizing depreciation expense and accumulated

depreciation (a contra-asset).

b. Adjustment 2 – Insurance expense

i. This is a cash exchange that took place in February.

ii. The expense was deferred until incurred (insurance coverage was provided).

iii. The adjustment involves recognizing insurance expense and reducing prepaid

insurance.

c. Adjustment 3 – Interest expense

i. This is a cash exchange that will take place in the future (when the loan is

repaid).

ii. The expense needs to be accrued because it has been incurred (someone else’s

money was used).

iii. The adjustment involves recognizing interest expense and interest payable (a

liability).

Applying Your Knowledge: Ratio Analysis (LO 5)

I. Financial ratios are comparisons of different amounts on the financial statements.

II. Profit margin on sales

a. Profit margin on sales is a ratio that measures how much of the firm’s sales revenue

actually makes its way to the bottom line – net income.

b. Equal to net income divided by net sales.

Teaching Tip

Obtain several companies’ balance sheets and calculate and compare the profit margin on sales

of each.

Business Risk, Control, and Ethics (LO 6)

I. Three risks are associated with financial information:

a. Errors in recording and updating the financial accounting records

i. These errors can be costly.

ii. Controls that can minimize the risk of these errors include:

1. Input and processing controls

2. Reconciliation and control reports

3. Documentation to provide supporting evidence for the recorded

transactions

b. Unauthorized access to the accounting information

c. Loss of data in the accounting data

CHAPTER 3 NAME ___________________________________

TEN-MINUTE QUIZ Section _____________ Date____________

_____________________________________________________________________________

_

_____ 1. An accrual is a transaction in which:

a. The recognition occurs before the exchange of cash

b. The exchange of cash occurs before the recognition

c. The exchange of cash and recognition occur at the same time

d. The exchange of cash will not occur

_____ 2. A deferral is a transaction in which:

a. The recognition occurs before the exchange of cash

b. The exchange of cash occurs before the recognition

c. The exchange of cash and recognition occur at the same time

d. The exchange of cash will not occur

_____ 3. Interest expense is incurred:

a. When cash is paid to the lender

b. As time passes

c. When money is borrowed

d. When the loan is repaid

_____ 4. Which of the following is a typical example of a deferred expense?

a. Prepaid insurance

b. Supplies

c. Both of the above

d. None of the above

_____ 5. Unearned revenue is:

a. A revenue account that appears on the income statement

b. An asset account that appears on the balance sheet

c. An expense account that appears on the income statement

d. A liability account that appears on the balance sheet

_____ 6. Prepaid insurance is:

a. An expense

b. A liability

c. An asset

d. A revenue

_____ 7. Supplies expense is recognized when:

a. Cash is paid for the supplies

b. The supplies are used or consumed

c. Cash is received for the supplies

d. All of the above

_____ 8. Depreciation is an example of:

a. A deferral adjustment

b. An accrual adjustment

c. A decline in market value

d. A cash transaction

_____ 9. Accumulated depreciation is:

a. A liability

b. An expense

c. A contra-asset

d. An amount saved to purchase a new asset

_____ 10. Abacus Company has the following balances:

Current assets $30,000

Current liabilities 20,000

Stockholders’ equity 60,000

Net sales 100,000

Net income 20,000

What is the company’s profit margin on sales?

a. $60,000

b. $80,000

c 20%

d 60%

ANSWER KEY – CHAPTER 3 – TEN-MINUTE QUIZ

A

B

C

D

C

B

A

C