Accounting for Accruals and Deferrals

Overview of Accrual and Deferral Accounting

Definitions

• Accrual Accounting: A method of accounting where revenue and expenses are recognized as they are incurred, regardless of when cash is exchanged.

  • Accrual: A revenue or expense that is recognized before cash is exchanged.

  • Deferral: A revenue or expense that is recognized after cash has been exchanged.

Key Events in Cato Consultants' Accounting

Event 1: Establishing the Company

• Date: January 1, Year 1

• Transaction: Cato Consultants started by acquiring $5,000 cash by issuing common stock.

• Transaction Type: Asset Source Transaction

  • Classification: Financing Activities

Event 2: Consulting Services Provided

• Date: Year 1

• Transaction: Provided $84,000 of consulting services to clients but has not yet collected any cash.

• Transaction Type: Asset Source Transaction

  • Accounts Affected:

    • Retained Earnings (increased due to revenue)

    • Accounts Receivable (debt reflects that cash has not yet been received)

Event 3: Cash Collection from Customers

• Transaction: Cato collected $60,000 cash from customers as partial settlement of accounts receivable.

• Transaction Type: Asset Exchange Transaction

  • Classification: Operating Activities

Event 4: Salary Expense Payment

• Transaction: Cato paid $10,000 cash for teaching training courses (salary expense).

• Transaction Type: Asset Use Transaction

Event 5: Advertising Expense Payment

• Transaction: Cato paid $2,000 cash for advertising costs incurred in Year 1.

• Transaction Type: Asset Use Transaction

Event 6: Consulting Services Contracts

• Transaction: Signed contracts for $42,000 of consulting services to be performed in Year 2.

• Remark: Not recognized in Year 1 financial statements.

Event 7: Accrued Salary Expense

• Transaction: At the end of Year 1, Cato recorded accrued salary expense of $6,000 for courses taught by an instructor in Year 1, to be paid in Year 2.

• Transaction Type: Claims Exchange Transaction

  • Important Note: These are called accrued expenses; adjusting entries are updates that don't affect cash.

  • Accounts Affected:

    • Salaries Payable: A liability account indicating the cash amount due in the future.

Summary of Financial Transactions and General Ledger

Recorded Transactions and Their Effect on Accounts

Transaction Data for Year 1

1. Cato acquired $5,000 cash by issuing common stock.

2. Provided $84,000 consulting services on account.

3. Collected $60,000 cash from customers, reducing accounts receivable.

4. Paid $10,000 in salary expense.

5. Paid $2,000 for advertising expenses.

6. Signed contracts for future services worth $42,000.

7. Recognized $6,000 of accrued salary expense.

Accounts Overview

• Assets

  • Cash: Increased, starting from 0 to 53,000 by end of Year 1.

  • Accounts Receivable: Increased by 84,000 and decreased by 60,000.

• Liabilities

  • Salaries Payable: Increased by 6,000.

• Stockholders’ Equity

  • Common Stock: Increased by 5,000.

  • Retained Earnings: Increased by net income over the year.

Financial Statements for Year 1

Income Statement

• Consulting Revenue: $84,000

• Expenses incurred:

  • Salary Expense: $16,000

  • Advertising Expense: $2,000

• Net Income: $66,000

Statement of Changes in Stockholders' Equity

• Beginning Common Stock: $0

• Issued Common Stock: $5,000

• Ending Common Stock: $5,000

• Ending Retained Earnings: $66,000

• Total Stockholders' Equity: $71,000

Balance Sheet

• Total Assets: $77,000

  • Cash: $53,000

  • Accounts Receivable: $24,000

• Total Liabilities: $6,000

• Total Stockholders’ Equity: $71,000

Statement of Cash Flows

• Beginning Cash Balance: $0

• Cash Collected from Customers: $60,000

• Cash Paid for Expenses: $12,000 (Total of salary and advertising payments)

• Ending Cash Balance: $53,000

Temporary vs. Permanent Accounts

Temporary Accounts

• Include: Revenues, Expenses, Dividends

• Purpose: Track financial results for a limited period.

Permanent Accounts

• Include: Assets, Liabilities, Stockholders' Equity

• Purpose: Track financial results from year to year.

Closing Process

Steps for Closing Accounts

1. Transfer consulting revenue balance to retained earnings.

2. Transfer salary expense balance to retained earnings.

3. Transfer advertising expense balance to retained earnings.

The Accounting Cycle

Steps

1. Record transactions.

2. Adjust accounts.

3. Prepare statements.

4. Close temporary accounts.

Matching Concept

• Cash basis accounting can distort net income measurements as it does not always align revenue and expenses with when they are incurred or earned.

• Objective of Accrual Accounting: Ensure expenses are matched with the revenues they generate.

Period Costs

• Expenses that align with the period they are incurred, enhancing the accuracy of financial reporting.

Deferrals Impact on Financial Statements

• Unearned Revenue: Cash received before services provided, impacting when revenue is recognized.

Year-End Adjustments Examples

1. Settling salaries payable through cash payment.

2. Recognizing supplies expense based on physical count after determining unused supplies.

Recognizing Other Expenses

• Rent Expense Calculation:

  • Based on monthly payments and duration of lease used.

  • For a rent of $12,000 annually; monthly: rac{12,000}{12} = 1,000.

  • For 10 months of usage: 1,000 imes 10 = 10,000.

Closing Entries for Year 2 Transactions

• Recognizing accrued salaries, handling unearned revenue based on actual services performed.

• Transaction Types: Include asset source, asset use, claims exchange, as classified for each corresponding financial action taken by Cato Consultants.

Year 2 Event Classification

1. Cash to settle salaries payable (AU).

2. Purchase of supplies on account (AS).

3. Recognize supply expense based on inventory count (Adj.).

4. Recognize unearned revenue as earned when services are offered (CE).