Chapter 3
Timing is Everything
in Accounting
Accrual Basis Accounting
¡ You learned in the last module that
GAAP requires accrual basis accounting.
¡ This means 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 recognition of
revenue and expenses…not disbursing or
receiving cash.
Accruals
The action takes place
before dollars are
exchanged.
Action first,
dollars later
Deferrals
Cash is received or
paid before revenue is
earned or an expense
is incurred.
Dollars first,
action later
Accruals Deferrals
REVENUE EXPENSES REVENUE EXPENSES
AR Payables Unearned Prepaid
revenue insurance,
rent, supplies
Interest Interest
receivable payable
Let’s start with ACCRUALS:
Accruals Deferrals
REVENUE EXPENSES REVENUE EXPENSES
AR Payables Unearned Prepaid
revenue insurance,
rent, supplies
Interest Interest
receivable payable
Accrued Revenue
¡ Action has happened: we’ve earned the
revenue.
¡ We need to record it –recognize it on the income
statement—even though we will not get the cash
until later.
¡ We make a sale; we record accounts receivable.
We’ve accrued the revenue.
¡ At the end of the period, we have earned
interest on a Certificate of Deposit (CD) but have
not received it: we will record the interest
revenue (income statement) and interest
receivable (balance sheet). This is called
accruing interest revenue.
Accruing Revenue
The firm has a $1,000 investment that pays
4%. It has had the Investment for the
entire year, but the interest will not be
received Until the beginning of next year.
Interest revenue of $40 will need to be
recorded.
Assets = Liabilities + CC + RE
40 interest 40 interest
receivable revenue
When the cash is actually received:
The firm will record the cash and
take the receivable off of the
books:
Assets = Liabilities + CC + RE
40 cash
(40) interest
receivable
No revenue is recorded when the cash is
received because the revenue has already
been recognized in the previous period.
Accrued Expenses
¡ Action has happened: we’ve incurred the
expense.
¡ We need to record it –get it on the income
statement to match the relevant revenue—even
though we will not pay the cash until later.
¡ We incurred an expense; we record some sort of
payable with it (salaries payable, for example).
¡ At the end of the period, we have incurred
interest expense on a loan, but we have not paid
it: we will record the interest expense (income
statement) and interest payable (balance
sheet). This is called accruing interest expense.
Accruing Expenses
Suppose the firm has an employee who earns $500
per week (for a 5-day week). Generally, salary
expense is recorded when the employee is paid
each Friday for that week’s work.
However, suppose the fiscal year ends on
Wednesday this year, so the firm must accrue
salary expense for the three days of that last week
so that it will be on the correct income statement.
Assets = Liabilities + CC + RE
300 salaries (300) salary
payable expense
When the employee is
actually paid on Friday:
The employee will receive $500 for the
week. Of that total, three days’ worth of
salary expense was recorded in the prior
year, and two days’ worth will be
recorded as an expense in the current
year.
Assets = Liabilities + CC + RE
(500) cash (300) salaries (200) salary
payable expense
Now let’s look at DEFERRALS:
Accruals Deferrals
REVENUE EXPENSES REVENUE EXPENSES
AR Payables Unearned Prepaid
revenue insurance,
rent, supplies
Interest Interest
receivable payable
Deferred Revenue
¡ Dollars have been received, but no action has
taken place.
¡ We need to record the cash –put it on the
balance sheet—even though we will not earn
the revenue until later.
¡ We sell a gift card. We record the receipt of the
cash along with a liability called Unearned or
Deferred Revenue. We “owe” somebody
something.
¡ When we actually earn the revenue, then we
recognize the revenue (record it on the income
statement) and take off the liability because we
have satisfied it by earning the revenue.
Recording Deferred Revenue
Suppose the firm sold a gift card
amounting to $60. When the firm
received the cash, it recorded
unearned or deferred revenue.
Assets = Liabilities + CC + RE
60 cash 60 unearned
revenue
When the gift card is used:
The firm will record the revenue
and take the unearned revenue
off of the books:
Assets = Liabilities + CC + RE
(60) Unearned 60 revenue
revenue
This is “recognizing” the revenue—recording it
so that it shows up on the income statement.
Deferred Expenses
¡ We’ve paid for something (dollars first) but we
have not incurred the expense.
¡ We need defer its recognition–keep it off the
income statement until we use it. Then, we’ll
record the expense to match the relevant
revenue.
¡ We pay in advance; we record some sort of
asset with the cash disbursement (prepaid
insurance, prepaid rent, etc.)
¡ When we actually use the goods or services for
which we paid in advance and previously
booked as assets, we will reduce (or remove) the
asset and record an expense.
Recording a Deferred Expense:
Suppose that on January 1, a firm pays in
advance for 18 months of insurance at a
cost of $1,800. When the firm pays for this,
an asset called Prepaid Insurance is
recorded. (No expense is recorded
because none of it has been used at the
date of the payment.) Here’s what the
firm would record:
Assets = Liabilities + CC + RE
(1,800) cash
1,800 prepaid
insurance
When the firm prepares its year-
end financial statements:
Some of the insurance has been used up
(by the passage of time). 12 months’ worth
have been used and need to be
recorded as insurance expense; 6 months’
worth is still unused at year end and will
remain in the prepaid insurance account.
Assets = Liabilities + CC + RE
(1,200) prepaid (1,200)
insurance insurance
expense
To summarize:
¡ Timing is very important in accounting.
¡ We want to be sure to get the revenue
and expenses for ONLY this accounting
period on this period’s income statement.
¡ The income statement is based on revenue
that has been earned (whether or not the
related cash has been collected) and
expenses that have been incurred (whether
or not the related cash has been paid).
¡This is ACCRUAL BASIS accounting.