Accounting for Accruals and Deferrals Notes

Fundamentals of Accrual Accounting

• Accrual accounting is defined as recognizing revenue when it is earned and expenses when they are incurred, regardless of when cash changes hands.

• There are two primary timing differences in accrual accounting:

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

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

Transaction Analysis: Year 1 Case Study (Cato Consultants)

• Event 1: Initial Investment

  • On January 1, Year 1, Cato Consultants acquired $5,000$ cash by issuing common stock.

  • Classification: Asset Source Transaction.

• Event 2: Revenue Recognition (Accrual)

  • During Year 1, Cato provided $84,000$ of consulting services to clients on account (not yet collected).

  • Classification: Asset Source Transaction.

  • This increases Accounts Receivable and Retained Earnings (Revenue).

• Event 3: Collection of Accounts Receivable

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

  • Classification: Asset Exchange Transaction.

  • Total assets remain unchanged as Cash increases and Accounts Receivable decreases by the same amount.

• Event 4: Payment of Salary

  • Cato paid the instructor $10,000$ cash for teaching training courses.

  • Classification: Asset Use Transaction.

  • This is recorded as Salary Expense.

• Event 5: Payment for Advertising

  • Cato paid $2,000$ cash for advertising costs shown in Year 1.

  • Classification: Asset Use Transaction.

• Event 6: Future Contracts

  • Cato signed contracts for $42,000$ of consulting services to be performed in Year 2.

  • This event is not recognized in Year 1 financial statements because the service has not been performed and no cash has changed hands.

• Event 7: Accrued Salary Expense

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

  • Classification: Claims Exchange Transaction.

  • An expense is recognized (decreasing Retained Earnings) and a liability is recognized (increasing Salaries Payable).

  • Adjusting Entries: These update accounting records at the end of a period and do not affect cash flows.

  • Salaries Payable: A liability account representing an obligation to pay cash in the future.

Financial Statements for Year 1

• Income Statement:

  • Reflects accrual accounting concepts.

  • Consulting Revenue: Includes the price charged for all services performed ($84,000$), even if cash was not received.

  • Expenses: Include all costs incurred to produce revenue, regardless of payment status.

  • Definition of Expense: A decrease in assets or an increase in liabilities resulting from operating activities undertaken to generate revenue.

• Statement of Changes in Stockholders’ Equity:

  • Reports effects of issuing common stock, earning net income, and paying dividends.

  • Identifies the specific increases and decreases in stockholders’ equity during the period.

• Balance Sheet:

  • Discloses an entity’s assets, liabilities, and stockholders’ equity at a particular point in time.

  • For Cato Consultants: Total Assets equal $77,000$.

  • This is balanced by obligations to creditors (Liabilities: $6,000$) and commitments to stockholders (Stockholders' Equity: $71,000$).

• Statement of Cash Flows:

  • Explains the change in cash from the beginning of the period ($0$) to the end ($53,000$).

  • Summary of Year 1 Cash Flow:

    • Collected $60,000$ from customers.

    • Paid $12,000$ for expenses ($10,000$ salary + $2,000$ advertising).

    • Acquired $5,000$ via common stock issuance.

The Accounting Cycle and Closing Process

• Matching Concept:

  • A primary goal of accrual accounting is to match expenses with the revenues they produce in the period they are incurred.

  • Period Costs: Expenses that are matched with the specific period in which they are incurred.

  • Cash basis accounting is avoided because it fails to match expenses and revenues correctly when cash timing differs from service delivery.

• Account Types:

  • Temporary Accounts: Track financial results for a limited period. Includes Revenues, Expenses, and Dividends. These are closed at the end of the year.

  • Permanent Accounts: Track financial results from year to year. Includes Assets, Liabilities, and Stockholders' Equity.

• Closing Process: The process of transferring the balances of temporary accounts to the Retained Earnings account at the end of the accounting cycle.

Transaction Analysis: Year 2 Case Study (Deferrals and Adjustments)

• Event 1: Settlement of Liability

  • Cato pays $6,000$ cash to the instructor to settle the salaries payable from Year 1.

  • Classification: Asset Use Transaction.

• Event 2: Purchase of Supplies

  • Cato purchases $800$ of supplies on account.

  • Classification: Asset Source Transaction.

• Year-End Adjustment for Supplies:

  • A physical count on December 31 reveals $150$ of unused supplies remain.

  • Supplies Expense is recognized for the amount used: $800 - 150 = 650$.

• Event 3: Prepaid Rent

  • On March 1, Year 2, Cato pays $12,000$ cash to lease office space for one year (March 1 to February 28).

  • Classification: Asset Exchange Transaction (Cash decreases, Prepaid Rent increases).

• Year-End Adjustment for Prepaid Rent:

  • At the end of Year 2, Cato must recognize rent expense for the 10 months used (March through December).

  • Calculation: $\frac{10}{12} \times 12,000 = 10,000$.

  • The remaining $2,000$ remains on the balance sheet as Prepaid Rent (an asset).

• Event 4: Unearned Revenue

  • On June 1, Year 2, Cato receives $18,000$ cash in advance from Westberry Company for one year of services.

  • Classification: Asset Source Transaction (Cash increases, Unearned Revenue liability increases).

• Year-End Adjustment for Unearned Revenue:

  • Cato recognizes the portion of revenue earned during Year 2 (June through December = 7 months).

  • Calculation: $\frac{7}{12} \times 18,000 = 10,500$.

  • The remaining $7,500$ remains as a liability (Unearned Revenue).

Transaction Classification Categories

Accounting events are classified into one of four primary categories:

1. Asset Source Transactions: An asset account increases and a corresponding claims account (liabilities or equity) increases.

2. Asset Use Transactions: An asset account decreases and a corresponding claims account (liabilities or equity) decreases.

3. Asset Exchange Transactions: One asset account increases and another asset account decreases; total assets remain unchanged.

4. Claims Exchange Transactions: One claims account (liabilities or equity) increases and another claims account decreases; total claims remain unchanged.