| Chapter Three - Accruals and Deferrals |
Accruals:
Whenever we borrow money, there is a cost associated with it – Interest (Time is money)
The formula for interest is: Interest = Principal * Rate * Time The actual cash payment is immaterial; every day that goes by when you have borrowed money, you are incurring a very real expense. This is an accrual.
Example: You borrow $1,000 at 6% for one year on August 1. You need to record expenses for the December 31st year-end financial statements. How much interest expense should you record?
$1,000 * 6% / 12 months * 5 Months = $25 interest expense Note: interest rates are ANNUAL rates, unless otherwise stated Note: make the annual rate a monthly rate by dividing by 12 months
Then multiple by the number of months the loan is outstanding Aug., Sept., Oct., Nov., Dec. = 5 months (Note: August 1st)
The same method is used if we loan the money to a friend, except that we would receive $25 interest revenue Since there is no cash exchanged we use accrual accounts
Offsetting the interest expense is “Interest Payable,” a liability Offsetting the interest revenue is “Interest Receivable,” an asset
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Deferrals:
What if we receive cash before we perform our responsibilities regarding a sale?
Then we OWE the customer. We will record a liability. Since we haven’t earned the money yet, we use the account “Unearned Revenue” Consider a magazine subscription – a person pays you $24 for 12 issues of your famous magazine. You owe that person 12 magazines or their money back.
What if we pay cash to another party before we realize the expense?
We have future rights for the unused product or service – these are assets Examples are insurance and rent. You buy car insurance in 6 month intervals. You pay $1,200 starting on Nov. 1st How much expense should be recorded for the year and what is the prepaid amount?
$1,200 / 6 months = $200 per month Expense: = 2 months (Nov. and Dec.) * $200 = $400 insurance expense Prepaid: = 4 months (Jan., Feb., Mar., Apr.) * $200 = $800 Prepaid Insurance
Supplies – You swap cash (an Asset) for supplies (an Asset) like pens and paper
- There is no effect on income; you are swapping an asset for an asset.
- You recognize an expense only as you use up those supplies
Equipment – You are typically paying large sums of money for an asset with a long life
Consider a $25,000 car. You wouldn’t want to take that expense in one year, when it will last you FIVE years. So we allocate the cost of the equipment over its life (Depreciation) NOTE: We do not reduce the value of the asset account directly, instead we create a CONTRA-account to offset the asset account – Accumulated Depreciation (still an asset) The net value of the asset will decrease each year as accumulated depreciation increases
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