Accruals and Deferrals

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. 

Chapter 4 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

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

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 anytime 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

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.

The following month when the customer picks up the computer and pays for it, the company will record the receipt of payment as follows.
 

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).

The following month when the company pays the installer, they will record the payment, as follows.
 

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

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 1) match the appropriate expense with the month it relates to, and 2) eliminate 
 

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.

And the entry to record January insurance expense at the end of the month.
 

And finally, the Ledger accounts.

Prepaid Insurance declines each month as the expense is transferred from the Balance Sheet to the Income Statement.

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. 

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).

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 exaple 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).
 

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. 

The straight line method is only one method used to calculate depreciation. The subject will be covered more in Chapter 9. 

Book Value & Salvage Value

Book value is the difference between the cost of an asset, and the related accumulated depreciation for that asset. 

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 (Chapter 9).
 

Adjusting Journal Entries

All companies must make adjusting entries at the end of a year, before preparing their annual financial statements. Some companies make adjusting entries monthly, to prepare monthly financial statements. 

Adjusting entries fall outside the routine daily journal entries and activities of special departments, such as purchasing, sales and payroll. Accountants make adjusting and reversing journal entries in a way that does not interfere with the efficient daily operations of these essential departments.

Adjusting entries should not be confused with correcting entries, which are used to correct an error. That should be done separately from adjusting entries, so there is no confusion between the two, and a clear audit trail will be left behind in the books and records documenting the corrections.

In practice, accountants may find errors while preparing adjusting entries. To save time they will write the journal entries at the same time, but students should be clearly aware of the difference between the two, and the need to keep them separate in our minds. 

Adjusting entries don't involve the Cash account. Any adjustments to Cash should be made in with the bank reconciliation (Chapter 7), or as a correcting entry.

Adjusting entries involve a balance sheet account and an income statement account. Here are some common pairs of accounts and when you would use them. 

Notice most examples follow general rules: Revenues are credited, Expenses are debited, receivables are debited, payables are credited. 

The Supplies or Inventory accounts need to be adjusted to reflect the physical amount of inventory or supplies at the end of the year. With Supplies we will count the physical items, for instance: 3 boxes of paper, 4 dozen pens, etc. and calculate a total value for supplies on hand, based on what we paid for the items originally. The Supplies account will be increased or decreased, as needed, to bring it to the correct balance.
 

Correcting entries

A correcting entry should be entered whenever an error is found. If errors are found at the end of the year, while preparing financial statements, accountants usually go ahead and correct the error at that time. There are various reasons a correction might be needed. A wrong account or dollar amount might have been entered. The entry could have used a debit, when a credit should have been entered. 

Errors will carry through to the financial statements, so it is important to detect and correct them. The type of error should be noted, and brought to management's attention, if the accountant feels the error might be intentional. Intentional errors are called "falsifications" and are an indication there might be fraud.
 

Reclassifications
A reclassification is a correction entry used to correct a mis-classification or to change the classification of an entry. This might be necessary if an entry is made without complete information. For instance, the company might purchase a building and land for a single price. The two assets need to be entered separately. The company may have to wait for an appraisal, and will make a journal entry to record the purchase, then reclassify a portion of the purchase price to allocate the correct values to the land and building.

Reversing entries

A reversing entry is a very special type of adjusting entry. They can be extremely useful and should be used where necessary. A reversing entry comes in two parts: the original adjusting entry, and the reverse, or opposite entry. The second entry is written by simply reversing the position of all debits and credits. Ultimately, the end result on the books is zero, but the adjusting entry serves to correctly allocate an expense, so the financial statements are correct. 

Let's look at an example. X Company has a payroll department, and cuts checks every two weeks after tabulating hours, and calculating net pay. A large number of allocations have to be made to various withholding accounts. The accountants don't want to interfere with the operations of the payroll department. And the employees also want the department to run efficiently so they can get their pay checks on time.

At the end of the year the accountants need to appropriately allocate payroll expenses, plus taxes due and payable. Rather than interfere with the payroll department the calculation is made on paper (or computer), and entered as an adjusting entry. It is marked to be reversed. After the closing entries are made, the first entries of the new year are the reversing entries. They undo the effects of the adjusting entry.

If the adjusting entry is not reversed, the books will not be correct. Both the accountants and payroll department will be making entries related to payroll. The reversing entry effectively allows the accountants to make adjusting entries without causing the books to be incorrect; the payroll department continues to make routine entries, and doesn't need to make any special entries or allocations.

Until you actually work with reversing entries they seem strange. Here's how the numbers play out. Let's look at a really simple example. 

X Company's payroll expense is $1,500 per week; they pay salaries every two weeks. Assume that December 31 falls at the end of the week, and in the middle of the pay period. The payroll expense for the two week period needs to be split between two years, with $1,500 in year 1 and $1,500 in year 2. 

At the end of the first week in January the payroll department will make its journal entry to record the two week payroll. But that journal entry will be for $3000, and not $1500 as it should be. Two things need to happen: 1) $1500 needs to be accrued in the year 1 financial statements; 2) the first week of year 2 needs to be adjusted, because it will record too much payroll expense.

If this adjusting entry is made, the year 1 payroll expense will be correct:

After the books are closed for the year the reversing entry is made, dated the first day of the new year. The Payroll Expense account carries a credit balance, which is not the normal balance for an expense account, and would normally indicate an error in posting or classifying the transaction. But for a reversing entry this is correct.

After the payroll department post the 2-week payroll the Payroll Expense account will be correct. The balance is a debit of $1500, which is exactly what the Payroll Expense account should have for one week's payroll. If the reversing entry had not been made, the Payroll Expense account would need to be adjusted, because it would be overstated by $1500.