The Accounting Cycle

Accruals and Deferrals

Chapter 4

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Chapter 4: The Accounting Cycle—Accruals and Deferrals

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 Adjusting Entries

Adjusting Every
entries are adjusting
needed whenever entry involves a
revenue or expenses change in either a
affect more than one revenue or expense
accounting and an asset
period. or liability.

4-2

At the end of the period, we need to make adjusting entries to get the
accounts up to date for the financial statements.

The accrual basis dictates that revenues be recognized when earned and
expenses be recognized when incurred. The accrual basis of accounting is
considered to be in compliance with generally accepted accounting principles,
GAAP. Every adjusting entry involves a revenue or expense and an asset or
liability.

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 Types of Adjusting Entries

  Converting
Converting liabilities to
assets to revenue
expenses

 Accruing  Accruing
unpaid uncollected
expenses revenue

4-3

There are two broad categories of adjustments.

The first is when payments are made or cash is received before the expense or
revenue is recognized. This category includes prepaid or deferred expenses
(including depreciation), and unearned or deferred revenues.

The second major category of adjustments is when cash is paid or received

after the expense or revenue is recognized. These are very common
adjustments. This category includes accrued expenses and accrued revenues.

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 Converting Assets to Expenses
End of Current Period

Prior Periods Current Period Future Periods

Transaction Adjusting Entry

Paid cash in  Recognizes portion
advance of of asset consumed
incurring as expense, and
expense  Reduces balance of
(creates an asset account.
asset).

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When an adjusting entry is used to convert an asset to expense, a transaction

took place in a prior period that involved the advance payment of an expense.
Three common examples of adjusting entries to convert assets to expenses
are the recognition of depreciation expense on plant assets, the using up of
office supplies during the period, and the expiration of prepaid insurance.

The adjusting entry is made at the end of the current period to recognize the
converting of the prepaid asset into an expense. The asset account is reduced
and the expense account is increased.

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 Converting Assets to Expenses
$18,000 Insurance Policy
Coverage for 12 Months

$1,500 Monthly Insurance Expense

Mar. 1 Feb.28

On March 1, Overnight Auto Services

purchased a one-year insurance policy
for $18,000.
4-5

Assume that on March 1, Overnight purchased for $18,000 a one-year

insurance policy providing comprehensive liability insurance and insurance
against fire and damage to customers’ vehicles while in Overnight’s facilities.
Therefore, 1/12 of this cost, or $1,500, is recognized as insurance expense
every month.

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 Converting Assets to Expenses

Initially, costs that benefit more than one

accounting period are recorded as assets.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Mar. 1 Unexpired Insurance 18,000
Cash 18,000
Purchase a one-year insurance policy.

4-6

Here is the entry made by Overnight on March 1 to record the purchase of the
policy. A debit, or increase, is made to the asset Unexpired Insurance, and a
credit, or decrease, is made to the asset account Cash for $18,000.

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 Converting Assets to Expenses

The costs are expensed as they are

used to generate revenue.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Monthly Adjusting Entry for Insurance
Mar. 31 Insurance Expense 1,500
Unexpired Insurance 1,500
Adjusting entry to record insurance expense for March.
4-7

At the end of March, Overnight is going to prepare its financial statements.

The proper adjusting entry is to debit, or increase, the expense account

Insurance Expense and to credit, or decrease, the asset account Unexpired
Insurance for $1,500.

Overnight will make this adjusting entry at the end of each month.

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 Converting Assets to Expenses

Balance Sheet Income Statement

Cost of assets Cost of assets
that benefit used this period to
future periods. generate revenue.

Unexpired Insurance Insurance Expense

3/1 18,000 3/31 1,500 3/31 1,500
Bal. 16,500

4-8

After posting the adjusting entry to the general ledger accounts, it’s clear that
the asset, Unexpired Insurance, has been partially converted into the expense
account Insurance Expense.

Both the asset account and the expense account are now carried at their
proper balances.

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 The Concept of Depreciation
Depreciation is the systematic allocation of
the cost of a depreciable asset to expense.

Fixed The asset’s Depreciation

Asset usefulness is Expense
(debit) partially (debit)
consumed
On date during the
At end of
when initial period. period . . .
payment is
made . . . Accumulated
Cash Depreciation
(credit) (credit)

4-9

Depreciation is the systematic and rational allocation of the cost of a

depreciable asset to expense over its estimated useful life. There are many
methods of depreciation; the straight-line method will be examined in this
chapter.

As a depreciable asset is used to produce revenue, the asset loses some of its
utility and part of the asset is consumed. At the end of the accounting period,
the expense relating to the consumption of the depreciable asset must be
recorded.

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 Depreciation Is Only an Estimate
On Jan. 22, 2015, Overnight Auto Service
purchased a building with a useful life
of 240 months for $36,000.
Using the straight-line method, calculate
the monthly depreciation expense.
Depreciation
Cost of the asset
expense (per =
Estimated useful life
period)

$150/month = $36,000
240
4-10

On January 22nd, Overnight purchased a building with a useful life of 240

months or 20 years. The building cost $36,000. Overnight uses the straight-
line method of depreciation and records depreciation expense monthly.

Depreciation expense is equal to the cost less any anticipated salvage value
divided by the estimated useful life.

So, Overnight should record depreciation expense of $150 per month. Let’s
look at the adjusting entry required.

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 Depreciation Is Only an Estimate

Overnight Auto Service would make the

following adjusting entry.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Feb 28 Depreciation Expense: Building 150
Accumulated Depreciation: Building 150
To record one month's depreciation.

Contra-asset
4-11

The adjusting journal entry required on Dec 31st is to debit, or increase,

Depreciation Expense on Building and credit, or increase, the account
Accumulated Depreciation on Building. We will assume that Overnight did not
record any depreciation expense in January because it operated for only a
small part of the month. Therefore, at the end of February, one month’s
depreciation or $150 would be recorded.

The account Accumulated Depreciation on Building is a contra asset account.

A contra account is a reduction in an associated account. In this case,
Accumulated Depreciation will be shown on the balance sheet as a reduction
in the Building account.

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 Depreciation Is Only an Estimate
Overnight depreciates its $12,000 of tools
and equipment over 60 months. Calculate
monthly depreciation and make the journal
entry.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Feb 28 Depreciation Expense: Tools and Equipment 200
Accumulated Depreciation: Tools and Equipment 200
To record one month's depreciation.

$12,000  60 months = $200 per month

4-12

Remember that Overnight purchased tools and equipment costing $12,000.

The tools and equipment have an estimated useful life of five years, or 60
months. Can you calculate depreciation expense for the month of February on
the newly acquired tools and equipment (assuming that no depreciation is
recorded for the partial month of January)? When you are finished, go to the
next screen.

The proper adjusting entry is to debit Depreciation Expense on Tools and

Equipment for $200, and credit Accumulated Depreciation on Tools and
Equipment for the same amount.

The Accumulated Depreciation account will appear on the balance sheet as a

reduction in the Tools and Equipment account.

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 Depreciation Is Only an Estimate
We will assume that Overnight did not record any
depreciation expense in January because it
operated for only a small part of the month.

December 31, 2015 Balance Sheet Presentation

Building $ 36,000
Less: Accum. depr. 1,650 34,350
Tool and Equipment $ 18,000
Less: Accum. depr. 2,200 15,800

Cost - Accumulated Depreciation = Book Value

4-13

This slide shows how Overnight shows its building and tools and equipment
on the asset section of the balance sheet at December 31, 2015. Notice that
the contra accounts are subtracted from the related asset account. The cost of
an asset less the accumulated depreciation is equal to book value of that
asset. Book value is not intended to represent an asset’s current market value.
Total accumulated depreciation for 2015 is calculated by multiplying the
monthly depreciation expense by 11 months.

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 Converting Liabilities to Revenue
End of Current Period

Prior Periods Current Period Future Periods

Transaction Adjusting Entry

Collect cash in  Recognizes portion
advance of earned as revenue,
earning revenue and
(creates a  Reduces balance of
liability). liability account.

4-14

Now let’s look at the adjusting entry associated with converting a recorded
liability to a revenue. The adjusting entry is necessary when cash has been
collected in advance of earning revenue. An example is when a magazine
publishing company collects cash for a one- or two-year subscription. Other
examples of transactions that require an adjusting entry to convert a liability
to revenue are the sales of airline tickets, or season tickets for a sports team.

At the end of the accounting period, an adjusting entry will need to be

recorded to recognize the revenue earned during the period and to reduce the
liability account.

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 Converting Liabilities to Revenue

$3,000 Rental Contract

Coverage for 3 Months

$1,000 Monthly Rental Revenue

Dec. 1 Feb. 28

On December 1, Overnight received $3,000

in advance for a three-month rental contract.
4-15

Overnight Auto Services begins to rent space in its garage. On December 1st,
Harbor Cab Co. agrees to rent space in Overnight’s building to provide indoor
storage for some of its cabs. The agreed-upon rent is $3,000 per month, and
Harbor Cab paid for the first three months in advance. Because Overnight
prepares monthly financial statements, it should recognize $1,000 per month
in rental revenue on December 31. Let’s see how this transaction was
recorded by Overnight.

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 Converting Liabilities to Revenue

Initially, revenues that benefit more than one

accounting period are recorded as liabilities.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec 1 Cash 3,000
Unearned Rent Revenue 3,000
Collected $3,000 in advance for rent.

4-16

On December 1st, Overnight debited Cash for $3,000 and credited the liability
account called Unearned Rent Revenue for the same amount.

Don’t let the word revenue in the liability account title mislead you. The
important descriptor is the word Unearned. Unearned revenue is a liability.
Overnight must do something to earn this revenue.

Let’s look at the journal entry required on December 31st to recognize the
revenue earned during the month.

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 Converting Liabilities to Revenue

Over time, the revenue is recognized

as it is earned.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Monthly Adjusting Entry for Rent Revenue
Dec 31 Unearned Rent Revenue 1,000
Rental Revenue 1,000
Adjusting entry to record rental revenue for December.
4-17

On December 31st, Overnight would debit, or reduce, the liability account

Unearned Rent Revenue and credit, or increase, the Rental Revenue account
for $1,000, one-month’s rent earned.

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 Converting Liabilities to Revenue

Balance Sheet Income Statement

Liability for Revenue earned
future periods. this period.

Unearned Rental Revenue Rental Revenue

12/31 1,000 12/1 3,000 12/31 1,000
Bal. 2,000

4-18

The balance in the Unearned Rental Revenue account represents 2 months of

unearned rent at $1,000 per month.

The balance in the Rental Revenue account for December is $1,000. This
amount will appear on Overnight’s income statement.

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 Accruing Unpaid Expenses
End of Current Period

Prior Periods Current Period Future Periods

Adjusting Entry Transaction

 Recognizes expense Pay cash in
incurred, and settlement of
 Records liability for liability.
future payment.

4-19

One of the keys to understanding the accrual of expenses is to realize that an

expense has been incurred in the current accounting period but will not be
paid until the following accounting period. For example, you may purchase
gasoline from the local service station using a credit card. You have incurred
the expense for the gasoline but have not recorded the cost. You probably will
not record your expense until the following period when the credit card
statement comes. Companies cannot follow this practice because expenses
would be recorded in the wrong accounting period and thus violate the
matching principle.

The adjusting entry required is to debit, or increase, an expense account and

credit, or increase, a liability account. Almost all expense accruals will require
this type of entry. Some common accrued expenses include interest owed on
loans, wages and salaries owed to employees, and property taxes owed to the
local taxing authority.

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 Accruing Unpaid Expenses
Friday,
$1,950 Wages Jan. 3
Expense

Monday, Tuesday,
Dec. 30 Dec. 31

On Dec. 31, Overnight owes wages of

$1,950. Payday is Friday, Jan. 3.

4-20

Here is an example of accrued wages. Overnight, like many businesses, pays

its employees every other Friday. This month, however, ends on a Tuesday—
three days before the next scheduled payday. Thus Overnight’s employees
have worked for more than a week in December for which they have not yet
been paid. Time cards indicate that since the last payroll date, Overnight’s
employees have worked a total of 130 hours. Including payroll taxes,
Overnight’s wage expense averages about $15 per hour. Therefore, at
December 31, the company owes its employees approximately $1,950 for
work performed in December. Can you prepare the adjusting journal entry
required of Overnight on December 31st?

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 Accruing Unpaid Expenses

Initially, an expense and a liability are

recorded.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec 31 Wages Expense 1,950
Wages Payable 1,950
Adjusting entry to accrue wages owed to employees.

4-21

As with most expense accruals, Overnight will debit an expense account, in

this case Wages Expense, for $1,950 and credit a liability account, in this case
Wages Payable, for $1,950.

The wages earned by employees during December will be recorded in the

proper period.

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 Accruing Unpaid Expenses

Balance Sheet Income Statement

Liability to be Cost incurred this
paid in a future period to generate
period. revenue.

Wages Payable Wages Expense

12/31 3,000 12/31 1,950

4-22

The balance in the Wages Payable liability account is $1,950 and will appear
on the balance sheet of Overnight at December 31st.

The Wages Expense account will be increased by $1,950, and this amount will
be included on December’s income statement.

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 Accruing Unpaid Expenses
$2,397 Weekly Wages

$1,950 Wages $447 Wages

Expense Expense

Monday, Tuesday, Friday,

Dec. 30 Dec. 31 Jan. 3

Let’s look at the entry for Jan. 3.

4-23

Employees earned an additional $447 on Wednesday through Friday, January

1-3. Let’s look at the entry Overnight will make on payday, Friday, Jan. 3rd.

We need to be careful because part of the $2,397 of total wages expense has
already been recognized.

Try to make this entry to record the wages on Jan. 3rd before going to the next
screen.

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 Accruing Unpaid Expenses

The liability is extinguished when the

debt is paid.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Jan 3 Wages Expense (for Jan.) 447
Wages Payable (accrued in Dec.) 1,950
Cash 2,397
Weekly payroll for Dec. 30 - Jan. 3.
4-24

Wages Expense should have a debit for $447, the portion of the total payroll
applicable to January. Next, eliminate the Wages Payable by debiting the
account for $1,950. The balance in the Wages Payable account is now zero.
Finally, credit the Cash account for the full cost of the payroll, $2,397.

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 Accruing Uncollected Revenue
End of Current Period

Prior Periods Current Period Future Periods

Adjusting Entry Transaction

 Recognizes revenue Collect cash in
earned but not yet settlement of
recorded, and receivable.
 Records receivable.

4-25

A revenue accrual is necessary when revenue has been earned in the current
accounting period but the cash will not be collected until the next period.
Examples of revenue accruals include interest earned on investments or loans
made to others, and work completed but not yet billed to the customer.

In the adjusting entry we will record a receivable, an asset account, and

recognize the revenue earned.

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 Accruing Uncollected Revenue
$750 Repair
Service
Revenue

Dec. 15 Dec. 31 Jan. 15

On Dec. 31, Airport Shuttle owes Overnight

half of it maintenance agreement. The one-
month fee of $1,500 is to be paid is to be
paid on the 15th day of January.
4-26

In December, Overnight entered into an agreement to perform routine

maintenance on several vans owned by Airport Shuttle Service. Overnight
agreed to maintain these vans for a flat fee of $1,500 per month, payable on
the fifteenth of each month.

No entry was made to record the signing of this agreement, because no

services had yet been rendered. Overnight began rendering services on
December 15, but the first monthly payment will not be received until January
15.

Overnight needs to make an adjusting entry at December 31 to record half of

the revenue earned from the agreement with Airport Shuttle during
December. From the 15th of December until December 31st, Overnight earned
$750 of the maintenance fee.

Let’s make the adjusting entry to recognize the interest earned from
December 15th to December 31st.

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 Accruing Uncollected Revenue

Initially, the revenue is recognized and

a receivable is created.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec 31 Accounts Receivable 750
Repair Service Revenue 750
Adjusting entry to record accrued service revenue.

4-27

Overnight will debit the asset account, Accounts Receivable, for $750 and
credit the Repair Service Revenue account for the same amount.

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 Accruing Uncollected Revenue

Balance Sheet
Income Statement
Receivable to
Revenue earned
be collected in a
this period.
future period.

Accounts Receivable Repair Service Revenue

12/31 750 12/31 750

4-28

The asset, Accounts Receivable, will appear on Overnight’s balance sheet at

December 31st. The Repair Service Revenue account will be shown on
Overnight’s income statement for the month ended December 31st.

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 Accruing Uncollected Revenue
$1,500 Monthly Interest

$750 Service $750 Service

Revenue Revenue

Dec. 15 Dec. 31 Jan. 15

Let’s look at the entry for January 15.

4-29

Overnight earned an additional $750 from the 1st of January until the 15th
when the service fee was paid. Overnight will receive a total of $1,500 on
January 15th.

Once again, be careful because part of the $1,500 has already been
recognized as revenue. Try to record the entry for the receipt on January 15th
before going to the next screen.

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 Accruing Uncollected Revenue

The receivable is collected in a future

period.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Jan 15 Cash 1,500
Repair Service Revenue (for Jan.) 750
Accounts Receivable (accrued Dec. 31) 750
To record cash collected for monthly maintenance fee.

4-30

First, debit the asset account, Cash, for the full $1,500. Next, credit the Repair
Service Revenue account for $750, the amount earned during the month of
January. Finally, eliminate the Accounts Receivable account for $750. This
must be done because the cash has now been received for service provided in
December.

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 Accruing Income Taxes Expense:
The Final Adjusting Entry
As a corporation earns taxable income, it
incurs income taxes expense, and also a
liability to governmental tax authorities.

GENERAL JOURNAL

Date Account Titles and Explanation Debit Credit

Dec. 31 Income Taxes Expense 4,020
Income Taxes Payable 4,020
Adjusting entry to record income taxes accrued in December.

4-31

A corporation must pay income tax on its taxable income. This liability is paid
in four installments called estimated quarterly payments. The first three
payments normally are made on April 15, June 15, and September 15. The
final installment actually is due on December 15; but for purposes of our
illustration and assignment materials, we will assume the final payment is not
due until January 15 of the following year.

It is always necessary to accrue income taxes for a corporation. The adjusting

entry is just like the entry we record for any accrued expense. In 2015,
Overnight earned income before income taxes of $66,570. Income taxes
expense for the entire year is estimated at $26,628 ($66,570 X 40 percent).
Since Overnight has recognized income tax expense through November 30
amounting to $22,608, the December accrual will be for the amount of $4,020
(or $26,628 - $22,608).

The adjusting entry is to debit Income Taxes Expense for the amount of the
accrual and credit Income Taxes Payable for the same amount. In this case,
the taxes accrued are $4,020.

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 Adjusting Entries and Accounting
Principles
Costs are matched with revenue
in two ways:

 Direct association of costs

with specific revenue
transactions.

 Systematic allocation of costs

over the “useful life” of the
expenditure.
4-32

Adjusting entries help us match costs with revenues either directly by

associating certain costs with specific revenues, or through the allocation
process. Allocation was used to record depreciation expense in this chapter.

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 The Concept of Materiality
An item is “material” if knowledge of the
item might reasonably influence the
decisions of users of financial statements.

Many companies
immediately charge
the cost of Light bulbs
immaterial items to
expense.
Supplies
4-33

Generally, accountants are most concerned about amounts that are

determined to be material in nature. An amount is material if it may influence
the decision of an informed user of financial information.

When amounts involved are not material, many companies have established a
policy of expensing the amount immediately. We know that light bulbs may
last through several accounting periods. It is not cost beneficial to record the
bulbs as assets and allocate a portion of their cost to each month of
operation. We normally expense the cost of these and similar items as they
are incurred.

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 Effects of the Adjusting Entries
Income Statement Balance Sheet
Net Owners'
Adjustment Revenue Expenses Income Assets Liabilities Equity
Type I
Converting Assets to Expenses No effect Increase Decrease Decrease No effect Decrease
Type II
Converting Liabilities to Revenue Increase No effect Increase No effect Decrease Increase
Type III
Accruing Unpaid Expenses No effect Increase Decrease No effect Increase Decrease
Type IV
Accruing Uncollected Revenue Increase No effect Increase Increase No effect Increase

4-34

We identified four types of adjusting entries, each of which involves one

income statement account and one balance sheet account. The effects of
these adjustment types on the income statement and balance sheet are
summarized on this slide.

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  After these
adjustments are
posted to the
ledger,
Overnight’s
ledger accounts
will be up-to-
date (except for
the balance in
the Retained
Earnings
account).

4-35

We have highlighted just a few of the adjusting entries prepared at the end of
December 2015. Like the trial balance, the adjusted trial balance shows that
the total of the debit balance accounts is equal to the total of the credit
balance accounts. Our books are in balance after recording our adjusting
entries.

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 End of Chapter 4

4-36

End of Chapter 4.

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