Unit 4: Accruals And Deferrals
The realization principle, as explained in unit 2 requires that revenue be recognized and recorded in the period it is earned. And the matching principle stresses that in order to measure income; expenses incurred to produce revenues must be matched (associated) with the revenue generated in the same accounting period.
At the end of an accounting period, adjusting entries are needed so that all revenues earned are reflected in the financial statements regardless of whether they have been collected or not. Adjusting entries are also needed for expenses to ensure that all expenses incurred are matched against the revenues of the current period regardless of when cash payment of the expense occurs.
Thus, adjusting entries help in achieving the goals of accrual accounting – which states recording revenues when it is earned and recording expenses when the related goods and services are used, i.e. when expenses are incurred.
Accountants use adjusting entries to apply accrual accounting to transactions that span more than one accounting period. That is, adjusting entries are needed whenever transactions affect the revenues or expenses of more than one accounting period.
4.2 Types of Adjusting Entries
A business may need to make a dozen or more adjusting entries at the end of each accounting period. The exact number of adjustments will depend up on the nature of the company’s business activities. But, all adjusting entries fall in to two general categories:
- Adjusting entries to apportion deferrals
- Adjusting entries to record accruals
4.3 ACCOUNTING FOR DEFERRALS
Definition: - The word “defer” means to delay or post pone. In accounting, Deferrals are the delay (or post ponment) in the recognition of an expense already paid or revenue already received.
Deferred items consist of adjusting entries involving data previously recorded in accounts. These entries involve the transfer of data already recorded in asset and liability accounts to expense and revenues accounts.
Types of Deferrals
Deferred items could be grouped into two major types:
- Deferrals to apportion prepayments
- Deferrals to apportion advance receipts
4.3.1 Accounting Treatment for Prepayments (Deferred Expenses)
Companies often make advance expenditures that benefit more than one period, before receiving the service. Such expenditures that are made before receiving the service are called Prepaid Expenses or Deferred Expenses. At the initial point of payment, the total advance payment is an asset not an expense to the business enterprise paying in advance. This is because, according to the accrual basis of accounting, the recognition of expense is not related to the payment of cash. Rather it is related to the receiving of the service; that is, incurring of the expense. As far as the company has not received the service the total advance payment remains to be an asset to the business enterprise.
However, each time the company receives the service, the asset will be converted to an expense. That is, the part of the advance expenditure that has benefited current operations is treated as an expense of the period in which the service is received as you can see, each time the service is received (expense incurred) no payment will be made, because the payment has already been made in advance.
And the part of the advance payment that has not been consumed or has not been expired (used) is treated as an asset applicable to future operations. It is through the use of adjusting entries that we apportion (divide) the prepayment in to used and unused portion. The adjusting entry for the adjustment of prepayments uses an asset and expense accounts.
There are two alternative methods of recoding prepayment at the initial point of payment.
- The asset method
- The expense method
We have tried to discuss the asset method of recording prepayments in the previous chapters. In this chapter, we will see both methods to help you understand the alternative methods of recording prepayments.
To illustrate the alternative methods of recording prepayments, assume on Jan. 1,2002 CHAMO ADVERTIZMENT COMPANY paid Br. 36,000 for rent for the coming three years for office it has rented from SHALA COMPANY. Also, assume that the fiscal year of CHAMO ADV. COMPANY ends on December 31.
18.104.22.168 Recording Prepayments (Deferred Expenses) Initially in an Asset Account (The Asset Method)
The total advance payment is debited to an asset account, in CHAMO ADV. CO.S’ case to a Prepaid Rent Account. Recording the total advance payment in an asset account does not imply that it will remain to be an asset. As we mentioned earlier, at the initial point of payment, the total amount paid in advance is an asset. However, as each day passes, part of the asset expires and becomes an expense. In accounting, we don’t transfer the expired portion each day from the asset to an expense account. Rather we delay it until the end of the accounting period.
The adjusting entry used in this case, debits an expense account and credit an asset for the amount that has expired i.e. the portion for which service has been received.
Lets see these for CHAMO ADV. CO., On Jan. 2, 2002 the following journal entry will be made by CHAMO ADV. CO.
- Prepaid Rent ………………………… 36,000
Cash ………………………………… 36,000
To record advance payment of rent for 3 years.
As you can notice, the total advance payment was debited to an asset account, and obviously as cash was paid the cash account is credited.
After one year on Dec. 31, 2002, the company has used the office for one year. We say from the total advance payment, Br. 12,000 (= Br. 36,000/3 Br. 12000) has expired. But until adjustment, the used portion Br. 12000 remains in the asset account; it is through adjustment that we transfer the used portion to an expense account.
The adjusting entry that transfers the used portion to the expense account for CHAMO ADV. CO. made on Dec. 31,2002 is:
Rent Expense ……………… Br. 12,000
Prepaid Rent ………… ………….. Br. 12,000
After the adjusting entry has been posted, the Rent Expense account will have a balance of Br. 12,000 and prepaid Rent now shows the correct balance of Br. 24,000 (The portion that has not expired or used). This relationship can be shown using a “T” account as follows:
Prepaid Rent Rent Expense
Dr. Cr. Dr. Cr.
Jan. 1,2002 36,000 12,000 Dec. 31, 2002 Dec. 31,2002 12,000
(Payment) (Adjusting) (Adjusting)
Balance Br. 24000
The used portion Br. 36000 = Br. 12000
is transferred from the asset to an expense account
If CHAMO ADV.CO. decides to leave the office it rented on Dec.31,2002, do you think that it will be refunded the amount it paid of Jan. 1,2002? No, because it has already used the office for one year. As a result, the amount it should be refunded is the unused portion of the prepayment. But in our case, CHAMO ADV. CO. has not decided to leave the office.
22.214.171.124 Recording Prepayments Initially in an Expense Account (The Expense Method)
In our illustration for CHAMO ADV. CO., advance payments for rent that will benefit three years operation were recorded by a debit to an asset account, Prepaid Rent. However, each time the service is used (i.e. stay in the office) it is obvious that the asset will be converted to an expense account. As a result some companies follow an alternative practice of recording prepayments directly to an expense by the assumption that the prepayment will be finally converted to an expense. Remember that, though the pre payment is recorded initially (directly) in an expense account, it still remains to be an asset to the company as far as the service is not received.
In CHAMO ADV.CO.’S case the following journal entry will be made on Jan. 1,2001, the date of advance payment.
Rent Expense ………………….. 36,000
To record advance payments made for rent for three years.
Recording the prepayment directly in an expense account doesn’t necessarily indicate that the total advance payment will expire during the year. That is, part of the prepayment might remain unexpired (unused) at the end of the year. When there is unused portion, an adjustment is needed to transfer the unused portion from the expense account to the asset account. The adjusting entry will debit an asset account and credit an expense account for the amount for which no service is received (unexpired petition).
On Dec. 31,2002, the following adjusting entry is made by CHAMO ADV. Company.
Prepaid Rent…………………………. 24000
To record the adjustment that transfer the unexpired portion from an expense to
The unexpired amount is computed as:
Yearly expiration = = Br. 12,000 per year. There fore, after one year only
1/3 (12,000) expires, the remaining balance Br. 24,000 (=Br. 36,000 – 12,000) is unexpired and reported as an asset.
This alternative method leads to the same results in the balance sheet and income statement, as does the asset method of recording. Here also, the balance of prepaid rent that will appear on the balance sheet is Br. 24,000 and the amount of rent expense for the year is Br. 12,000.
126.96.36.199 Effect of Overlooking Adjustments for Deferred Expenses
What is the effect of over looking the adjustment on the financial statements?
- The expenses would be over stated by Br. 24,000. Because it is through the adjusting entry that we apportioned the unexpired portion from the expense account and transferred to the asset account.
- The overstatement of expense leads to an understatement of net income (or overstatement of net loss if there is net loss).
- The understatement of net income will be reflected on the owners equity (capital) that is capital will be understated. Because through the closing process the understated income balance will be transferred to the capital account, hence the understatement of capital.
- The assets (Prepaid Rent) would be affected and understated, if the adjustment was over looked. Because it is through adjustment that we transfer the unexpired portion to the asset account. But if no adjustment, the unexpired portion remains in the expense account than being in the asset account.
Therefore, we say never, never over look an adjustment, for failing to do so will misstate all financial statements. And misstated financial statements will lead to WRONG DECISIONS.
4.3.2 Deferred Revenues (Unearned Revenues)
Just as expenses can be paid before they are used, revenues can be received before they are earned, i.e., before the service has been given. Unity University College collected money from you in advance of giving service. Such advance collections made before giving service are called Unearned Revenues.
When cash is received in advance, the company enters in to an obligation to deliver goods or perform services. Therefore, unearned revenues are shown in a liability account, and will appear on the Balance Sheet.
Unearned Revenues differ from other liabilities because unlike Accounts payable, they are usually settled by rendering services, than payment in cash. We can say it is a work off rather than a paid off liability. Of course, if the company fails to deliver the services as promised it must refund the customers their money for the portion it has not rendered the service.
Each time the company renders services it is earning the revenues. No cash collection will be made at this point, why? Because the cash has already been collected in advance.
Concerning the recording of Deferred Revenues, we have two alternative methods:
- Recording advance collections directly in a liability account
- Recording advance collection directly in a revenues account
The financial statements prepared using these two methods are one and the same. It is like two roads leading to the same place.
To help us understand the difference between the alternative methods, consider the following illustration:
On January 1,2001, Oceanic Advertisement Company collected Br. 18,600 in advance from ZOOM Company by promising to advertise the products of ZOOM Co. on Ethiopian Television and on one of the local news papers for the coming 20 months. Assume advertisement services given each month are equal.
188.8.131.52 The Liability Method: Recording Unearned Revenues Directly (initially) in a Liability Account
Amounts that are collected in advance from customers are not revenues of the business enterprise, as far as service is not provided. As a result, one approach to record the advance collections is to record them directly in a liability account; even if part or all of it might be earned during the period.
On Jan. 1, 2001, Oceanic Advertisement Company will record the advance collection as:
Unearned Advertisement Revenues ………………………18,600
Remember that the unearned advertisement Revenues is a liability account, not a revenue account. The Advertisement Revenues will be earned gradually as Ocean Co. gives the services as promised. Because it will not be practical to record weekly or monthly earnings of revenues, what we do is to delay weekly or monthly earning until the end of the fiscal period. By which time we will transfer the amount of Advertisement Revenues earned for the year from the liability account to the revenue account. The adjustment journal entry for this debits the liability account and credits the revenues account for the earned portion (the portion for which service has been rendered).
On Dec. 31,2001, the following adjusting entry will be made in the case of Oceanic Advertisement Company:
Unearned Advertisement Revenues ………………….11,160
Advertisement Revenues ……………………..11,160
To record adjustment
The amount that is earned can be computed as:
Monthly = Br. 18,600/20months = Br. 930 per month earnings.
i.e. each month the company earns Br. 930.00. Therefore, for the period from Jan.1,2001, to Dec.31,2001, Br. 11,160 (=12 x 930) is earned by Oceanic Advertisement Company.
After the adjusting entry has been posted, unearned Advertisement Revenue will have a Br. 7440 end balance and Advertisement Revenue will have a Br. 11,160 balance. The balance in unearned Advertisement represents the obligation of the company to render advertisement services in the future periods. This can be stated using a “T” account as follows:
Unearned Advertisement Revenue Advertisement Revenue
Br. 18,600 Jan. 1, 2001
Br. 11, 160 Br.7, 440 Br. 11, 160
To transfer the earned portion Br. 11,160
from the liability to the revenue account
What would be the effect of over looking the adjustment?
On the income statement:
- Revenues would be understated. This is because; it is through adjustment that we transfer the earned portion from the liability to the revenue account.
- Net income would be understated; or net loss would be overstated. Because there would be an understatement of revenue.
On the balance sheet
- Capital would be understated, because the understated net income would be closed finally to the capital account.
- The liability would be overstated in the Balance sheet because the adjustment has transferred out from the liability account to the revenue account the portion that is earned. But, if there was no adjustment this earned portion remains in the liability account and overstates it.
184.108.40.206 The Revenue Method: Recording Advance Collections Initially in a Revenue Account
We have stressed that amounts collected from customers in advance are liabilities not revenue because according to the revenue realization principle, revenue is earned when service is given to the customer.
However, we know that each time service is given we earn revenue. As a result, some companies prefer to record advance collections initially in a revenue account though it is not earned.
Here, the expectation is that, in the future all of the advance collections will be earned and be converted into revenue. Notice that, even if we record the advance collection in revenue accounts it doesn’t mean that it is revenue. It still remains to be a liability as far as service is not given.
On Jan. 1, 2001, the date of advance collection, Oceanic Advertisement Company will record the following journal entry:
Advertisement Revenue ---------------------------18,600
To record advance collections for advertisement
for 20 months
Recording the advance collection in revenue account does not necessarily imply that it will be earned totally in the period.
A portion of it might remain unearned. When there is unearned revenue at the end of the year an adjustment is necessary to transfer this unearned portion from the revenue account to the liability account.
In year 2001, Oceanic Advertisement Company rendered services only for 12 months from the total 20-month services it promised to give. Since the 8 months service is not rendered it should NOT be reported as revenue. As a result, using an adjusting entry, which debits the revenue account and credits the liability account, we transfer the unearned portion to the liability account.
On Dec. 31, 2001, the following adjusting entry is necessary for oceanic advertisement company:
Advertisement Revenue -------------------------------- 7440
Unearned Advertisement Revenue------------------------------------7440
After the adjusting entry is posted, the Advertisement Revenue account will have a balance of Br. 11,160 and unearned Advertisement Revenue will have a balance of Br. 7,440. Notice that, it is one and the same to the balance that resulted in the previous alternative.
220.127.116.11 Effect of Overlooking Adjustments for Deferred Revenues
What would be the effect of overlooking the adjustment?
On the income statement
- Revenues would be overstated by the amount of the adjustment, because it is through the adjustment that the unearned portion is apportioned from revenue account.
- Net income would be overstated
On the Balance Sheet:
- Liability (= unearned Advertisement Revenue) would have been under stated because it is through the adjusting entry that we transfer the unearned portion to the liability account. That is, if no adjustment, nothing would have been transferred to the liability account.
- Overstatement of owner’s equity thus results from the over statement of revenue or net income.
4.4 Accounting for Accruals
Definition: an accrual is the recognition of revenue or an expense that has arisen but has not yet been recorded.
The word “accrue” means to accumulate or grow in size. In accounting, an accrual is the recognition of revenue or an expense that has accumulated overtime but has not yet been recorded. In order to report a company’s financial position and profitability accurately, the accruals should be recognized (recorded) in the accounting period in which they occur.
As you can notice from the definition, we have basically two types of accruals in accounting. These are:
1 – Accrued Expense / Accrued Liability/
2 – Accrued Revenue /Accrued Assets/
4.4.1 Accrued Expenses /Accrued Liability/
Accrued expenses refer to expenses that are incurred but are both unpaid and unrecorded. When we say the expense is incurred; it means, “ the service has been received but the payment for it has not yet been made.” Since the incurred expense is not paid there is a sense of a liability, hence the name accrued liability.
Most expenses in accounting are paid whenever they are incurred. There are, however, some business expenses that accrue (accumulate) daily but are usually recorded when they are paid. Such expenses include, salary and wages paid to employees, and interest paid on borrowed money. As you know, employees work on a day-to-day basis but they are not paid on a daily basis. Rather there is an interval on which the payment is made. Therefore, we say these expenses accrue, that is, grow or accumulate over time.
Accrual (both accrued expenses and accrued revenues) in general need an adjusting entry when the end of the fiscal period comes before the date on which the expense is to be paid.
Mamush Bakery pays the salaries of its employees every Friday, for a five working days from Monday to Friday. (That is, the employees are paid on every Friday for the work they perform from Monday to Friday. The salary for five working days amounts to Br. 2500.
For the year 1998, the end of the fiscal year, Dec. 31, falls on Wednesday. What adjustment is needed on December 31 in relation to salary expense.
By the end of Dec. 31, 1998, the employees have already worked for three days (Monday, Tuesday, and Wednesday) but they will not be paid until the regular pay day on Friday, which lies on Jan. 2, 1999 in another fiscal period.
The salaries for the three days are rightfully an expense for 1998. As a result, the expense must be recorded and reported in 1998, in the year in which it is incurred (According to the expense recognition principle).
Since it is not paid on Dec. 31, 1998, there is a liability that the company owes to pay. The salary rate is Br. 2,500 for the workdays, then, the rate per day will be Br. 500 (= Br. 2500/5). Therefore, the expense for the three days is Br. 500 x 3 = Br. 1,500.f and the following adjusting entry should be made to recognize the accrued expense on Dec. 31, 1998:
Salary Expense -----------------1500
Salary Payable ------------------------------ 1500
The balance in salaries payable that will be reported as a liability on Mamush Baker’s balance sheet is Br. 1,500. And the Salary Expense of the three days Br. 1500 will be reported together with the salary expenses of the year on the income statement.
4.4.2 Effect of Overlooking Adjustment of Accrued Expenses
As we stated earlier, adjustment is a mandatory step in the accounting cycle because failing to do so will affect the amounts reported on the financial statements. As a result, the adjustment for recognizing accrued expenses must be made always by the end of the fiscal year.
In our case, if the adjustment on Dec. 31, 1998 was overlooked, the following will be reflected on the financial statements:
On the Income Statement
- Expenses would have been understated, because in the adjustment an expense account has been increased.
- Understatement of expense leads to an overstatement of net income (or an understatement of net loss, if there is net loss)
On the Balance Sheet
- Capital would have been overstated because of the overstatement of net income.
- Liability (salaries payable) would have been understated, because in the adjusting
entry a labiality account has been increased.
4.4.3 Accrued Revenues (Accrued Assets)
Accrued revenues are revenues for which a service has been performed or goods delivered but for which no entry has been recorded.
That is, the revenues have been earned but not both yet recorded and received.
Any revenues that have been earned but not recorded during the accounting period call for an adjusting entry that debits an asset account (= specifically a receivable) and credits a revenue account.
4.5 Reversing Entries: The Optional First Step in the Next Accounting Period
At the end of each accounting period, adjusting entries are made to bring revenues and expenses into conformity with the matching rule. That is, using adjusting entries at the end of the accounting period, we try to update the accounts of the business enterprise.
A reversing entry is a general journal entry made on the first day of the new accounting period that is the exact reverse of an adjusting entry made at the end of the previous period. Unlike adjusting entries, reversing entries are optional, i.e., without the use of reversing entries we can prepare correct financial statements.
A reversing entry, as the name implies, is the exact reverse of the adjusting entry made at the end of the previous period. It contains the same account titles and dollar amounts as the related adjusting entry, but the debits and credits are the reverse of those in the adjusting entry and the date is the first day of the next accounting period.
Reversing entries simplify the recording of certain routine cash receipts and payments and minimize the possibility of making errors.
Not all adjusting entries can be reversed. In accounting, when the policy of using reversing entries is adopted the adjusting entries to record the following adjustments can be reversed:
- Adjustments to record both types of accruals can be reversed.
- Prepaid expenses initially recorded as an expense can be reversed
- Unearned revenues initially recorded as a revenue can be reversed
N.B Deferrals that are recorded initially as an asset and as revenue cannot be reversed.
To show how reversing entries can be helpful, consider the following example.
- SAMRA COMPANY pays the salary of its employees each Friday for a five-day workweek. Assume salary per day is Br. 300.00, or Br. 1500 for a five-day week. Through out the year, the company’s accountant makes a journal entry each Friday as follows:
Salary Expense ---------------- 1500
Cash ------------------------------ 1500
To record payment of salary for the week.
Next, let us assume that December 31, end of the year 2002 falls on Wednesday. All expenses of the year must be recorded before the accounts are closed and financial statements are prepared on December 31. Therefore an adjusting entry must be made to record the salaries expense and the related liability for the three days (Monday to Wednesday) they have worked. The adjusting entry for $ 900.00 (computed as 3 x 300 daily salary expenses) is:
Dec. 31, 2002
Salary Expense 900
Salary Payable 900
To record accrued salary for the three days worked
The reversing entry would be:
Jan.1, 2003 Salary Payable 900
Salary Expense 900
To reverse adjustment made at the end of previous year.
After the reversing entry salary payable will have zero balance and salary expense will have a credit balance of 900 birr. Open T-accounts for both the salary expense and salary payable accounts and record adjustment, closing and reversing entries in the T-accounts ;you would get the fore mentioned balances.
The payment of salary on the following Friday would simply be recorded as follows:
January 2 Salary Expense…………..1500
The Choice of Method of Recording Deferrals
As you can recall, for both types of deferrals there are two methods of recording. That is, in the case of prepaid expenses the asset and expense methods and in the case of unearned revenues the liability and revenue methods of recording. Both alternative methods of recording deferrals result in the same effects on the financial statements. Then, the next logical question to ask is which method of recording to use.
The choice between the two methods of recording prepaid expenses and unearned revenues depends up on which method would normally result in fewer entries and would be least likely to create errors in the recording process.
It is better to record those prepaid expenses that will be used (consumed) during the accounting period initially as an expense. This way, only one entry would be required, and no adjusting entry is necessary. On the other hand, those prepaid expenses that will not be totally used or consumed during the accounting period are usually recorded initially as assets and an adjusting entry is made at the end of the period for the amount consumed.
Recording prepaid expenses that last for more than one period requires only an adjusting entry, but recording it initially as an expense would normally require both an adjusting entry and reversing entry.
Similarly, for unearned revenues that will be earned in the current accounting period, the revenue method of recording is preferable. In contrast, for unearned revenues that will be earned in more than one period the labiality method of recording is preferable.
Accountants have to update some of the accounting records or accounts before preparing the basic financial statements. The journal entries made at the end of the year to update the accounting records are called adjustment journal entries.
These can be adjustments for deferrals and adjustments for accruals.
Deferred expenses can initially be recorded either as assets or expenses. In any case, the accounts usually need adjustment. After adjustment the accounts reflect the same correct balance whichever method is followed. The same is true with deferred revenue. It can be recorded as a liability or as revenue when initially it is received.
The use of reversing entries is optional in all cases but it is recommended, as it will simplify matters in the following period.