Accounting Principles: Accruals, Deferrals, Revenue Recognition, and Closing (Chapters 1-8)

Accruals and Deferrals (Chapter 2) – Overview

• In chapter 2, we introduce accruals and deferrals as new types of transactions where cash is not exchanged at the same time as recognition.
• Concept: there can be a delay between recognition (recording the event) and realization (receiving or paying cash).
• Core idea: not every transaction involves immediate cash movement; some involve timing differences between earning revenue/incurring expenses and cash movement.
• The two new transaction types are accruals and deferrals, which affect how we record and present revenues and expenses on the financial statements.

Recording vs Recognizing vs Realizing

• Recognition: recording an event (revenue or expense) in the accounting records.
• Realization: the actual movement of cash associated with the event.
• In accruals, the sequence is typically: recognize the revenue/expense, then later realize the cash movement. In deferrals, cash moves first, and then the related revenue/expense is recognized later.
• GAAP requires that we match revenue and expenses to the period in which they occur (the matching concept).
• In chapter 1, cash and recognition happened simultaneously for both revenue and expense. In chapter 2, timing diverges due to accruals/deferrals.

Accruals: How they work

• An accrual involves recognizing an event first, then cash moves later (recognition precedes realization).
• Revenue side (accrual):
  • First, record Accounts Receivable (AR) and Revenue when you have earned the revenue but not yet received cash.
  • Later, when cash is collected, record the cash receipt and reduce AR.
• Expense side (accrual):
  • First, record Accounts Payable (AP) and Expense when you have incurred the expense but have not yet paid cash.
  • Later, when cash is paid, record the cash outflow and reduce AP.
• Example phrasing and accounts:
  • If you see revenue on account: AR (asset) increases and Revenue increases.
  • If you see expense on account: AP (liability) increases and Expense increases.
• AR is an asset representing cash to be received in the future; AP is a liability representing cash to be paid in the future.
• Mnemonic: AR mirrors revenue; AP mirrors expenses (seller’s AR mirrors buyer’s AP).
• How it appears in the basic accounting equation:
  • AR (asset) ↑ and Revenue (revenue contributes to SE) ↑ → asset source for revenue.
  • AP (liability) ↑ and Expense (expense reduces SE) ↑ → liability side involved with expense.
• Recognition vs. realization for accruals:
  • Recognition (accrual) typically occurs first; realization (cash collection) occurs later.
  • If revenue is earned before cash is received, you have AR; when cash is collected, you reduce AR and increase Cash.
  • If expense is incurred before cash is paid, you have AP; when cash is paid, you reduce AP and decrease Cash.

Deferrals: How they work

• Deferral is the opposite timing pattern: cash moves first, then the event is recognized later (recognition follows cash flow).
• Deferral patterns and examples:
  • Deferred expenses (prepaid expenses): you pay cash now, record an asset (e.g., Prepaid Rent, Prepaid Insurance). Over time, you recognize the expense as the asset is used.
  • Deferred revenue (unearned revenue): you receive cash now, record a liability (Unearned Revenue). Over time, as you perform the service or deliver the product, you recognize revenue.
• Examples:
  • Prepaid Rent: pay cash now for future rent; initially Dr Prepaid Rent, Cr Cash. Over time, Dr Rent Expense, Cr Prepaid Rent as the space is used.
  • Prepaid Insurance: similar to prepaid rent.
  • Supplies (deferral caveat): supplies are an asset; as you use supplies, they become an expense (no longer an asset).
  • Unearned Revenue: Dr Cash, Cr Unearned Revenue when cash is received; later, Dr Unearned Revenue, Cr Revenue as you fulfill the obligation.
• Deferral terminology and accounts:
  • Deferred expense: asset that will be expensed over time (e.g., Prepaid Rent, Prepaid Insurance, sometimes Supplies).
  • Deferred revenue (unearned revenue): a liability that becomes revenue over time as the obligation is fulfilled.
• Practical takeaway: when cash moves first, look for unearned revenue or prepaid expenses; when the event occurs later, recognize the corresponding revenue or expense.

The Accounting Cycle Context

• Step 1: Recording transactions (journal entries) – still happens, but timing may separate cash movement from recognition.
• Step 2: Adjusting entries – crucial for accruals and deferrals; these entries do not involve cash and are used to truing up accounts at year-end (Dec 31 is common in examples).
• Step 3: Prepare financial statements – four statements discussed in Chapter 1 (income statement, balance sheet, statement of cash flows, statement of shareholders’ equity).
• Step 4: Closing entries – close temporary accounts to permanent accounts (read-to-read mnemonic): close Revenue and Expenses and Dividends to Retained Earnings to reset for the next period.
• Closing entries (typical):
  • Close Revenue: Dr Revenue, Cr Retained Earnings.
  • Close Expenses: Dr Retained Earnings, Cr Expense (each expense is closed to Retained Earnings).
  • Close Dividends: Dr Retained Earnings, Cr Dividends.
• Balance check: ending balances must balance (Assets = Liabilities + SE).

The Four Basic Patterns of Transactions

• Asset Source: increase assets and increase claims (owner’s equity or liabilities) – financing sources (e.g., issuing stock) or revenue-generating activities.
• Asset Use: decrease assets and decrease claims – using up assets (e.g., paying an expense with cash).
• Asset Exchange: one asset changes without net change in total claims on assets (left side only movements).
• Claims Exchange: increases and decreases occur on the right side (liabilities and equity) while assets remain unchanged.

Practice Examples (Accruals, Deferrals, and Related Entries)

• Millie Inc. – Year 1 events (illustrative sequence): 1) Cash receipt from stock issuance: +20{,}000 cash; +20{,}000 common stock.
  • Transaction type: Asset Source; Activity: Financing.
    2) Services performed on account (revenue recognized but cash not yet received):
  • Revenue: +56{,}000; Accounts Receivable: +56{,}000; no cash effect.
  • Impact: Asset increase (AR) and Revenue increases; affects Retained Earnings via revenue. 3) Utility expense paid: cash outflow of 2{,}500; Utilities Expense: +2{,}500; effect on Retained Earnings via expense; Activity: Operating; Asset use (cash down). 4) Collected cash from AR: cash +48{,}000; Accounts Receivable -48{,}000; Asset Exchange; Operating activity. 5) Accrued salaries at year-end: Salaries Expense +10{,}000; Salaries Payable +10{,}000; no cash movement yet; Expense increases Retained Earnings reduction; Claims on the balance sheet (liability) increases. 6) Cash dividends paid: Cash -2{,}000; Dividends +2{,}000; Financing activity; Reduces Retained Earnings.
    • Ending balances provided: Cash 63{,}500; Accounts Receivable 8{,}000; Salaries Payable 10{,}000; Common Stock 20{,}000; Ending Retained Earnings 41{,}500.
• Life Inc. – Deferral and accrual practice (02:15a section):
  1) Unearned revenue cash received for services to be performed: + cash; Unearned Revenue +36{,}000; liability until earned; Operating cash flow impact: +36{,}000.
  2) Service performed (revenue earned): Revenue +54{,}000; cash not yet received in this step (since cash was previously received as unearned); cash flow impact: none at the moment; recognizes revenue now.
  3) Supplies purchased on account: + Supplies (asset) +2{,}800; + Accounts Payable +2{,}800; no cash movement yet.
  4) Paid portion of accounts payable: Cash -2{,}400; Accounts Payable -2{,}400; Operating activity; cash outflow.
  5) Paid cash dividend: Cash -5{,}000; Dividends +5{,}000; Financing activity.
  6) Another cash-based expense (described as paying cash for expense): Cash outflow -31{,}000; Expense recognized; Operating activity.
  7) Ending supplies on hand: Ending Supplies = 200; if purchases were 2{,}800 and ending is 200, then used supplies = 2{,}600; Recognize Supplies Expense = 2{,}600; Effect: decreases Retained Earnings; No cash movement in adjusting entry.
  8) Adjusting entries at year-end for service revenue (accrual): If service obligation covers 12 months from Apr 1 year 1, then by Dec 31 (9 months earned): Revenue recognized = 3{,}000 imes 9 = 27{,}000; Unearned Revenue decreases by the amount earned; Revenue increases accordingly; Cash flow unaffected by this adjustment.
• Key takeaway from the practice problems:
  • Unearned revenue is not revenue yet; do not include in income statement until earned.
  • For monthly revenue from a prepaid or deferred arrangement, allocate revenue evenly across the period of service.
  • Adjusting entries are usually date-specific (often Dec 31) and do not involve cash.

Journal Entry Templates (Accruals and Deferrals)

• Accrual (unearned revenue becomes revenue as earned):
  • Initial receipt (cash in, liability created):
  • Dr Cash X; Cr Unearned Revenue X
  • Revenue recognition over time:
  • Dr Unearned Revenue X/period; Cr Revenue X/period
• Accrual (revenue earned, cash later):
  • Initial recognition (AR and Revenue):
  • Dr Accounts Receivable X; Cr Revenue X
  • Cash collection:
  • Dr Cash X; Cr Accounts Receivable X
• Accrual (expense incurred, cash later):
  • Initial recognition (AP and Expense):
  • Dr Expense X; Cr Accounts Payable X
  • Cash payment:
  • Dr Accounts Payable X; Cr Cash X
• Deferral (prepaid expense):
  • Initial payment: Dr Prepaid Expense X; Cr Cash X
  • Expense recognition over time: Dr Expense X/period; Cr Prepaid Expense X/period
• Deferral (unearned revenue):
  • Initial receipt: Dr Cash X; Cr Unearned Revenue X
  • Revenue recognition over time: Dr Unearned Revenue X/period; Cr Revenue X/period
• Matching concept reminder:
  • Revenue and expenses are recognized in the period they are earned/incurred, not necessarily when cash is exchanged.
  • The two-step rhythm for accruals: recognition (on the earning side) followed by realization (on the cash collection side).

Formulas and Equations (LaTeX Formatted)

• Basic accounting equation: A = L + SE
• Revenue recognition timing (accrual):
  • Recognize Revenue: Revenue ext{ recognized}
    ightarrow AR ext{ increases (if on account)}
  • Realization (cash collection): Cash ext{ increases}
    ightleftharpoons AR ext{ decreases}
• Expense recognition timing (accrual):
  • Recognize Expense: Expense ext{ recognized}
    ightarrow AP ext{ increases (if on account)}
  • Realization (cash payment): Cash ext{ decreases}
    ightleftharpoons AP ext{ decreases}
• Deferral adjustments (examples):
  • Prepaid Rent (initial): ext{Dr Prepaid Rent}
    ightarrow ext{Cr Cash} \ ext{(amount)}
  • End-of-period adjustment (to recognize used portion): ext{Dr Rent Expense}
    ightarrow ext{Cr Prepaid Rent} \ ( ext{amount used})
  • Unearned Revenue (initial): ext{Dr Cash}
    ightarrow ext{Cr Unearned Revenue} \ ( ext{amount received})
  • End-of-period adjustment (to recognize earned portion): ext{Dr Unearned Revenue}
    ightarrow ext{Cr Revenue} \ ( ext{amount earned})
• Closing entries (to reset temporary accounts):
  • Close Revenue: Dr ext{Revenue accounts}
    ightarrow Cr Retained ext{ Earnings}
  • Close Expenses: Dr Retained ext{ Earnings}
    ightarrow Cr ext{Expense accounts}
  • Close Dividends: Dr Retained ext{ Earnings}
    ightarrow Cr Dividends
• End-of-period balance check:
  • Ensure A = L + SE holds after adjustments and closing entries.

Quick Reminders for Exam Prep

• When you see “on account” or “on credit,” expect accruals: AR or AP, depending on whether you’ll receive or pay cash in the future.
• “Paid” or “collected” signals cash movement; adjust activity type (operating, financing) accordingly.
• Deferrals involve cash before recognition; accruals involve recognition before cash.
• Recognize revenue or expense in the period earned/incurred, then recognize the corresponding cash movement later (accrual) or recognize cash movement first, then revenue/expense later (deferral).
• Use the four-step cycle and the red-to-read mnemonic to organize closing activities: close Revenue and Expenses to Retained Earnings, then close Dividends to Retained Earnings.
• Always check end balances for key accounts: cash, AR, AP, Salaries Payable, Common Stock, Retained Earnings, etc., to ensure the books balance and reflect the correct period results.