Accruals and Deferrals

In order for revenues and expenses to be reported in the time period in which they are earned or incurred, adjusting entries must be made at the end of the accounting period. Adjusting entries are made so the revenue recognition and matching principles are followed.

Four types of adjusting entries
1) converting assets to expenses
2) converting liabilities to revenue
3) accruing unpaid expenses
4) accruing uncollected revenues

Accounting systems are designed to handle a large number of routine transactions during the year very efficiently, usually with the aid of computers and devices like scanning cash registers, bar code inventory management systems and automatic credit card processing systems. The accounting system has the built-in capability to handle these items with little human intervention, creating appropriate journal entries, and posting thousands of transactions with little effort.

However, at the end of the year accountants must step in and prepare financial statements from all the information that has been collected throughout the year. An accounting system is designed to efficiently capture a large number of transactions. But this information is only partially in accordance to GAAP. The information needs a small amount of adjustment at the end of the year to bring the financial statements in alignment with the requirements of GAAP. And this is where adjusting entries come in.

GAAP also requires certain additional information, referred to as Notes to the Financial Statement. This is a combination of narrative and numerical information that must be prepared by a real live human. Computers can do many things, but the process of preparing financial statements requires professional judgment.

Accruals
- conditions are satisfied to record a revenue or expense, but money has not changed hands yet. Examples:

Accounts Receivable - work done or goods sold but the customer has not yet paid us

Accounts Payable - expenses incurred but we have not yet paid the supplier

These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred.

Example - Accrued Revenue (accounts receivable)
ComputerRx repairs computers. During March they fixed a computer, but the customer not picked it up or paid by the end of the month. The total value of the work done was $200, including parts, labor, etc.

The company should record both revenue and accounts receivable for $200 each. The work was done by the end of the month. Repair technicians were paid for their time and labor. Parts used in the repairs were also paid for. The company should record both the revenue and related expenses.

General Journal

Date	Account	Debit	Credit
Mar-31	Accounts Receivable	$200
	Computer Repair Revenue		$200
	To accrue revenue from repairs made during the month.

The following month when the customer picks up the computer and pays for it, the company will record the receipt of payment as follows.

Date	Account	Debit	Credit
Apr-15	Cash	$200
	Accounts Receivable		$200
	To record receipt of payments on account.

This is a generalized example of a journal entry. Many companies use an accounts receivable subsidiary ledger to keep track of each individual customer.

Example - Accrued Expense (accounts payable)
ComputerRx installs computer networks. They often hire an independent contractor to run cables for the network. They are billed twice a month at a rate of $1.50 per foot of installed cable, including parts and labor. At the end of the month they estimate the contractor installed 500 feet of cable that they had not been billed for.

The company should record an accounts payable for $750 ($1.50 x 500 ft).

General Journal

Date	Account	Debit	Credit
Mar-31	Installation Expense	$750
	Accounts Payable		$750
	To accrue installation expense at end of month.

The following month when the company pays the installer, they will record the payment, as follows.

Date	Account	Debit	Credit
Apr-10	Accounts Payable	$750
	Cash		$750
	To record payment on account.

Note, in both examples above, the revenue or expense is recorded only once, and in the correct month. The second journal entry reflects the receipt or payment of cash to clear the account receivable or payable.

Deferrals
- money has changed hands, but conditions are not yet satisfied to record a revenue or expense.

Prepaid Expenses - insurance, rent, advertising paid in advance but the expense shows up on future income statements.

Unearned Revenue - subscriptions, maintenance contracts paid in advance but the revenue shows up on future income statements.

These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred. Let's look at a time line and see how it works.

Deferrals are often referred to as allocations. Costs are spread over a number of months using a reasonable method of allocation. In the example below, we use the straight line method - an equal amount is allocated to each month. Other reasonable methods can be used as well.

Example - Deferred Expense
The company has an option of paying its insurance policy once per year, twice a year (2 installments) or monthly (12 installments). They decide to pay it twice a year, in January and July. To get a proper matching of expense to the period we spread each 6-month payment equally over the period the insurance policy covers. The effect of this is to 1) match the appropriate expense with the month it relates to, and 2) eliminate

Month>	Jan	Feb	Mar	Apr	May	Jun	total
$ spent>	$600	$0	$0	$0	$0	$0	$600
Expense taken	$100	$100	$100	$100	$100	$100	$600

Money is spent only once each 6 months, but the expense is allocated to each month by enter an adjusting journal entry in the books. Here's how the first journal entry would look.

General Journal

Date	Account	Debit	Credit
Jan-2	Prepaid Insurance	$600
	Cash		$600
	To record payment of 6 months insurance policy

And the entry to record January insurance expense at the end of the month.

Date	Account	Debit	Credit
Jan-31	Insurance Expense	$100
	Prepaid Insurance		$100
	To record one month insurance policy

And finally, the Ledger accounts.

General Ledger
Prepaid Insurance

Date	Description	Debit	Credit	Balance
Jan-2		$600		$600
Jan-31			$100	$500

Prepaid Insurance declines each month as the expense is transferred from the Balance Sheet to the Income Statement.

Insurance Expense

Date	Description	Debit	Credit	Balance
Jan-31		$100		$100

Example - Deferred Revenue
American Artist sells subscriptions to their magazine, published 12 times a year. A subscription costs $36 per year. People can subscribe at any time during the year. They record unearned subscription revenue when payment is received for a subscription.

General Journal

Date	Account	Debit	Credit
Apr-2	Cash	$36
	Unearned Subscription revenue		$36
	To record 1 year subscription received

Each month, as issues of the magazine are mailed, the company recognizes subscription revenue. How do they calculate their total subscription revenue? Each subscription earns them $3 per month ($36/12 issues). Last month they mailed out 3000 copies of the magazine. They will recognize $9,000 in subscription revenue
($3 x 3000 copies).

General Journal

Date	Account	Debit	Credit
Apr-30	Unearned Subscription revenue	$9,000
	Subscription revenue		$9,000
	To record 1 year subscription received

In both examples above, the company is transferring a deferred cost or revenue from the balance sheet to the income statement. We call this articulation.