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Financial Accounting:
A Business Process Approach
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
3-1
Chapter 3
Accruals and Deferrals:
Timing Is Everything in Accounting
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
3-2
Learning Objectives
When you are finished studying Chapter 3, you
will be able to:
1. Define accrual accounting and explain how
income is measured.
2. Explain accruals and how they affect
financial statements; describe and perform
the adjustments related to accruals.
3. Explain deferrals and how they affect
financial statements; describe and perform
the adjustments related to deferrals.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
3-3
Learning Objectives
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.
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3-4
Ethics Matters
Companies have been known to accrue
revenue that does not exist.
Archway Cookies needed to maintain its bank
Archway Cookies was owned by a
funding.
private
1. Maintain
equity
stock
firm prices.
that was not
Members
of the
equity
firm, Catterton
traded
on private
any stock
exchange.
Partners, and Archway Executives have
been named in lawsuits from former
employees
and access
distributors.
2. Maintain
to bank funding.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
3-5
Learning
Objective 1
Accrual Accounting
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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3-6
Measuring Income
The income statement summarizes revenues and
expenses for a period of time, usually a year.
Timing is everything in accounting.
The lifenames
of a business
is income
divided into
discrete
Other
for the
statement:
periods of time - months, quarters, or years.
• Statement of Operations
•Revenue
Statement
of Earnings
earned, not necessarily collected, in
time or
period
be included
on the
•one
Profit
Lossmust
(P&L)
Statement
income statement for that time period.
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3-7
Timing Differences
. . . when
revenues are
earned and
collected in
different
accounting
periods.
. . . when
expenses are
incurred in
one period
and paid for
in another.
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3-8
Accruals
Learning
Objective 2
The action takes
place before
dollars are
exchanged.
Sales made on
account
Interest
revenue
Action first,
cash
payment later
Purchases made
on credit
Interest
expense
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3-9
Adjustments for Accruals
Accruals that need to be made before the
financial statements are prepared are
“adjustments to the books.”
Revenue earned that has not been billed
(no receivable has been recorded)
Interest revenue that has been earned on
loans that has not been recorded
Expenses that have been incurred (used)
but have not been recorded (salary
expense)
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3-10
Accruals
Accounts Receivable: The amounts owed by
customers for goods and services for sales on
account, the most common accrual transaction.
The revenue is recorded at the time of sale, but
the cash for the sale will be collected later.
Recording revenue with an increase in accounts
receivable is called accruing revenue.
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3-11
Accruals
Another common accrual is for interest—
the cost of borrowing money.
If money is borrowed, interest expense and
interest payable (a liability) are recorded.
If money is loaned, interest revenue and
interest receivable (an asset) are recorded.
Interest rates always pertain to one year.
For loan periods of less than one year,
interest will be due for a fraction of one
year (6 months, 6/12).
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3-12
Accruals for Interest
On October 1, a company lends an employee $200
at 10% interest to be repaid on January 1 of the
next year.
When you lend money, the transaction decreases
assets (cash) and increases assets (other accounts
receivable). Total assets do not change.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
Retained
Earnings
(200) Cash
+200 Other
Receivables
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3-13
Accruals for Interest
Interest revenue is earned due to the passage of time. On
December 31, the company will accrue interest revenue.
(I)nterest = (P)rincipal X (R)ate X (T)ime
$5
=
$200 X .1
X 3/12
$5
= $200
X .10 X 3/12
The company earned $5 in interest revenue, but it has
not received the cash. Assets and retained earnings both
increase when the revenue and receivable are recorded.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
+5 Interest
Receivable
Retained
Earnings
+5 Interest
Revenue
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3-14
Accruals
Recognition of the event
versus realization of cash.
Recognizing a revenue or
expense means to record it in
the accounting records so that
it appears on the income
statement.
Realized means the cash is collected.
Sometimes revenue is recognized in one
accounting period and realized in a different
accounting period.
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3-15
Accruals
When the company receives the interest payment on
January 1, it will not be recorded as revenue. The
revenue was recognized (recorded) on December 31.
The cash will be realized (collected) and the asset
account, cash, will increase. The interest receivable
and other receivable asset accounts will decrease.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
Retained
Earnings
+205 Cash
(200) Other
Receivables
(5) Interest
Receivable
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3-16
Your Turn 3-1
Suppose your firm loaned an employee $1,000 at 7%
(interest rates are always assumed to be per year) on
July 1. On December 31, the firm is preparing its yearend financial statements. What adjustment would the
firm need to make to properly account for any interest
revenue that had been earned prior to year end?
The firm has earned $35, six months’ worth of interest.
The amount is ($1,000 X 0.07 X 6/12) = $35. The firm
would accrue the interest revenue with an increase to
revenue (retained earnings column of the accounting
equation) and an increase to an asset, interest
receivable.
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3-17
Accruals for Interest
You borrow $500 from a bank on January 1, 2010 and
agree to repay it with 8% interest on January 1, 2011.
When you borrow money, the transaction increases
assets (cash) and increases liabilities (notes payable).
The accounting equation is increased on both sides.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
+500 Cash
Retained
Earnings
+500 notes
payable
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3-18
Accruals for Interest
$40
= $500
Interest Payable: the amount
owed for borrowing money
Assets
= Liabilities
X .08
Interest Expense: cost of
using someone else’s money
+ Shareholders’ Equity
Contributed
Capital
+40 Interest
Payable
X 1 (year)
Retained
Earnings
(40)
Interest
Expense
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3-19
Accruals for Interest
No interest accrues in 2011, because you pay off
the loan January 01, 2011.
Assets decrease ($540 cash) and liabilities decrease
($40 Interest Payable and $500 Notes Payable).
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(540)
Cash
Retained
Earnings
(500) notes
payable
(40) Interest
Payable
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3-20
Accruals for Salaries
A firm’s accounting period ends on Monday,
December 31, 2012 and payday is every Friday.
Employees earn $3,500 for a 5-day workweek.
On December 31, one day’s salary expense is accrued.
Salary expense = 3,500/5= 700 per day X 1 day = 700.
Assets
= Liabilities
+
Shareholders’ Equity
Contributed
Capital
700 Salaries
Payable
Retained
Earnings
(700) Salary
Expense
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3-21
Accruals for Salaries
On January 4, employees will be
paid for the entire week.
How much salary expense is
recorded for work done in 2013?
Salary expense = $3,500/5= 700 per day X 4 days = $2,800.
Assets
= Liabilities
+Shareholders’ Equity
Contributed
Capital
(3,500)
cash
Retained
Earnings
(700) Salaries
Payable
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(2,800)
salary
expense
3-22
Your Turn 3-2
Suppose ABC Company pays its employees a total of
$56,000 on the 15th of each month for work done the
previous month. ABC generally records salary expense
when the employees are paid. If the ABC fiscal year end
is June 30, 2010, does any salary expense need to be
accrued at year end? If so, how much?
Yes, salary expense needs to be accrued. The expense
for June would routinely be recorded on July 15 when
the payment is made. To get the June salary expense
on the income statement for the year ended June 30,
ABC Company needs to accrue the expense. A month of
salary expense for June is recorded as salary expense
and salaries payable in the amount of $56,000.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
3-23
Learning
Objective 3
Deferrals
A deferral occurs when cash is
received or paid before
revenue is earned or an
expense is incurred.
Defer means to “put off or
postpone.”
Dollars
first, action
later
Unearned
Revenue
Prepaid
expenses
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3-24
Deferred Revenue
The company does not ship magazines until a
customer’s payment is received.
The company receives a check for $60 for a
twelve-month subscription.
Revenue is not recognized until the
magazines are delivered...but the company
must record the fact that it has received the
cash.
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3-25
Deferred Revenue
Unearned revenue is a liability that
represents the amount of goods or services a
company owes to its customers.
Cash has been collected, but revenue is not
earned until purchased items are shipped.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
+60 cash
Retained
Earnings
+60 Unearned
Revenue
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Deferred Revenue
When the
magazines sold are
actually shipped,
the company
recognizes the
revenue.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(5) Unearned
Revenue
Retained
Earnings
+ 5 Revenue
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3-27
Deferred Expenses
You’ve paid the cash “up-front” but you haven’t
received the goods or services yet.
Prepaid Expenses
Insurance
Rent
Supplies
Remember: DEFER
means to postpone.
Here, we postpone
recognizing the
expense until we
actually use the
goods or services.
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3-28
Prepaid Insurance
Companies pay insurance in advance. When the cash is
paid, the company has purchased an asset called prepaid
insurance.
On Oct. 01, the company paid $2,400 for one year’s
insurance coverage.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
Retained
Earnings
(2,400)
cash
2,400
Prepaid
insurance
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3-29
Prepaid Insurance
The passing of time signals the insurance is being used.
On Dec. 31st, an expense is recognized when the company
actually uses the insurance.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(600)
Prepaid
insurance
Retained
Earnings
(600)
Insurance
expense
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3-30
Prepaid Rent
Companies pay rent in advance. When the cash is
paid, the company has purchased an asset called
prepaid rent.
On November 1, the company paid $9,000 for three
months’ rent in advance.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
Retained
Earnings
(9,000)
Cash
+ 9,000
Prepaid
Rent
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Prepaid Rent
The passing of time is the action that signals
recognition of the expense.
The financial statements are prepared on
December 31.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(6,000)
Prepaid
Rent
Retained
Earnings
(6,000)
Rent Expense
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3-32
Supplies
A company paid $500 cash for
supplies during the month.
Supplies are recorded as an asset
when purchased.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
Retained
Earnings
(500)
Cash
+500
Supplies
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3-33
Supplies
Supplies are recognized as an expense after
they are used.
At the end of the month, $150 worth of supplies
are on hand.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(350)
Supplies
Retained
Earnings
(350)
Supplies
Expense
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3-34
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.
When a company buys an
asset that is used up in the
business 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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3-35
Depreciation
Suppose a company bought a computer for $5,000 cash.
The asset is expected to last five
years and have no residual value at
the end of its useful life.
How will the purchase of the asset
affect the financial statements?
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
Retained
Earnings
(5,000)
Cash
+5,000
Computer
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3-36
Depreciation Expense
DEPRECIATION EXPENSE: The portion of the cost
of an asset allocated to any one accounting period.
Accumulated Depreciation: Total
depreciation expense taken over the entire
life of the asset (a contra-asset account).
To depreciate the computer using the STRAIGHT LINE method:
Divide the cost of the asset (minus any estimated residual
value) by its useful life:
Cost – Residual Value
Estimated Useful Life
Annual depreciation expense and accumulated depreciation for
the computer is:
$5,000/5 = $1,000 each year
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3-37
Depreciation Expense
How will the use of the asset affect the financial statements?
Each year for five years, the computer’s book value
will be reduced on the balance sheet by $1,000.
Each year for five years, an expense of $1,000 will be
recognized on the income statement.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(1,000)
Accumulated
Depreciation
Retained
Earnings
(1,000)
Depreciation
Expense
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3-38
Learning
Objective 4
Accounting Equation
Transactions for Team Shirts for March 2010
Assets
=
Liabilities
+
Shareholders' Equity
Contributed
Capital
Beginning
Balances
All other
Assets
150
100
125
Cash
6,695
(Account)
= All Liabilities
(Account)
Accounts Receivable
800
Accounts Payable
Inventory
50
Other Payable
Prepaid Insurance
+
Retained
Earnings
+ Common Stock
Account
5,000
1,220
Transactions
1
2
(1,000)
(50)
4,000
3
4
150
(800)
(150)
5
6
(1,000)
1,000
2,000
Inventory
Accounts Receivable
(800)
Notes Payable
Other Payables
(800)
Accounts Payable
+
+
+
(100)
+
(50)
Computer
3,000
Accounts Receivable
Adjustment 1
(100)
Inventory
Accumulated
Depreciation
Adjustment 2
(50)
Prepaid Insurance
+
2,000
(800)
Adjustment 3
Ending
Balances
(50)
+
+
+
30
3,995
+
6,275
=
3,030
Interest Payable
(30)
+
5,000
+
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Sales
Cost of
Goods Sold
Depreciation
Expense
Insurance
Expense
Interest
Expense
2,240
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Accounting Equation
Preparing Team Shirts’ Financial Statements
1. The income statement is prepared first.
2. Net income can be used on the statement of
changes in shareholder’s equity.
3. The total contributed capital and retained
earnings from that statement are then used on
the balance sheet.
4. Finally, the cash transactions are
reorganized and summarized for the statement
of cash flows.
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3-40
Learning
Objective 5
Ratio Analysis
Profit Margin measures how much of the
firm’s sales revenue actually makes its
way to the bottom line – net income.
Hormel Foods Corporation profit margin
for fiscal year ending 10/28/2007:
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3-41
Your Turn 3-7
Use the following information from Campbell
Soup Company’s income statements to
calculate the company’s profit margin on sales
ratio. How does it compare with the ones
calculated for Hormel?
For the year ended
August 3, 2008
Net sales
$7,998
Net income
$1,165
For the year ended
July 29, 2007
$7,385
$ 854
For 2008: $1,165 ÷ $7,998 = 14.57%
For 2007: $ 854 ÷ $7,385 = 11.56%
The profit margin on sales ratio is growing, which is a
good thing.
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3-42
Learning
Objective 6
Business Risk, Control, and Ethics
Three significant risks associated with financial
information:
1. Errors in recording and updating the
accounting records.
2. Unauthorized access to the accounting
records.
3. Loss of the data in the accounting records.
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3-43
Learning
Objective 6
Business Risk, Control, and Ethics
The controls that can minimize these risks:
1. Input and processing controls are designed to
make sure that only authorized transactions are
put into the system.
2. Reconciliation and control reports are designed to
catch any errors in the input and processing of
the accounting data.
3. Documentation controls that provide supporting
evidence for the recorded transactions are designed
to keep errors from occurring and to catch errors
that have occurred.
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All rights reserved. No part of this publication may
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electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.
Copyright © 2011 Pearson Education, Inc.
publishing as Prentice Hall
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