UNIT -1 DEFERRALS AND ACCRUALS

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Deferrals

1.2.1 Types of Deferrals

1.2.2. Meaning of Deferrals (in general)
1.2.3. Meaning and Accounting Treatment of Deferred Items
1.2.3.1. Deferred Expense or Prepaid Expenses
1.2.3.2 Unearned Revenues.
1.3 Accruals
1.3.1. Meaning of Accruals (In Generals)
1.3.2. Types of Accruals
1.3.3. Meaning and Accounting Treatment for Accrued Items
1.3.3.1. Accrued Expenses or Accrued Liabilities
1.3.3.2. Accrued Revenues or Accrued Assets
1.4 Summary
1.5 Answers to Check Your Progress Exercise
1.6 Glossary
1.7 Model Examination Questions
1.8 Reference Books

1.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning of Deferrals and Accruals, accounting treatment, and
other aspects. After studying this unit, you will be able to:

- identify the reasons why adjusting entries must be made

- describe the basic characteristics of the accrual basis and cash basis of
accounting
- identify the classes and types of adjusting entries
- prepare adjusting entries, and

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 - define and use correctly the new terms in the glossary.

1.1 INTRODUCTION

Financial statements reflect revenues when earned and expenses when incurred. This is
known as accrual basis of accounting. Accrual basis of accounting uses the adjusting process
to recognize revenues when earned and to match expenses with revenues. This means the
economic effects of revenues and expenses are recorded when earned or incurred, not when
cash is received or paid. The cash basis of accounting means revenues are recognized when
cash is recorded and that expenses are recorded when cash is paid.

Decision makers need timely financial information because of the need for regular reporting
of information, But not all activities are complete at the time of financial statements are
prepared. This means we must make some adjustments in reporting to not mislead decision
makers. We rely on two principles in adjusting process.- revenues recognition and matching
principles. Revenue recognition principle requires that revenue be reported when Earned not
before and not after. Revenue is earned for most companies when services and products are
delivered to customers. These matching principle aims to report expenses in the same
accounting period as revenues that are earned as a result of these expenses. This matching of
costs (expenses) with benefits (revenues) is a major part of the adjusting process. There are
basic items, which require for adjusting entries. The first two items are deferrals and the
second two items are accruals.

1.2 DEFERRALS

1.2.1 Meaning of Deferrals (In General)

Deferral is the delay or postponement in the recognition of an expense already paid or a
revenue already received.

Deferrals are created by recording a transaction in away that delays or defers the recognition
of an expense or revenues.

1.2.2 Types of Deferrals

Deferrals are classified into two categories: deferred expenses or prepaid expenses and
deferred revenues or unearned revenues.

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1.2.3 Meaning and Accounting Treatment of Deferred Items

1.2.3.1 Deferred Expense or Prepaid Expense

Deferred expense or prepaid expenses are items that have been initially recorded as assets but
are expected to become expenses over time or through the normal operations of the business.
Most common deferred items include as supplies, prepaid insurance, prepaid advertising,
prepaid interest and depreciation and prepaid rent. Let us discuss how some of these accounts
would be treated in the reporting of financial information.

a) Prepaid Insurance (Prepayment of Insurance)

Insurance) – Assume that Unity company purchased
two years insurance policy (protection 1 beginning on Dec. 1, 1991, premium paid for two
years was Birr 2,400.00 when cash is paid, the journal entry would be:

Dec.1, 1991; Prepaid insurance……………..2,400.00

Cash……………………………2,400.00

With passage of time, the benefit of Insurance protection gradually expires and a portion
(part) of the prepaid Insurance asset becomes expense. For Example, One month’s Insurance
coverage expires by December 31, 1991. This expense is Birr 100, or 1/24 of Birr 2,400.00.
Our adjusting entry to record this expense and reduce the asset is:

Dec. 31 Insurance expense……………………100

Prepaid Insurance……………………….100
(To Record Expired Insurance)
Posting this adjusting entry affects the accounts as follows: (use- T account)

+ Prepaid Insurance -
Dec.1 2,400 Dec. 31, 100

-100
Bal. 2300
(Dec. 31)

If adjustment is not made as of Dec. 31, then (a) expenses are understated by Birr 100.00 and
net income overstated by Birr 100.00 for the December income statement, and

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(b) both prepaid Insurance and owner’s equity (because of net income) are overstated by Birr
100 in December 31 balance sheet. It is evident that 1992 adjustment must transfers a total of
Birr 1,200 from prepaid Insurance expense and 1993 adjustments must transfer the remaining
Birr 1,100 to insurance expense.

(b) Supplies - Supplies are another prepaid expense (deferred expense) often-requiring
adjustment. Example:
Example: Unity Company purchased Birr 3,720.00 of supplies in Dec. and used
some of them during this month. Consuming these supplies creates expenses equals to their
cost. Daily usage of supplies was not recorded in Unity Company accounts. Because this
information was not needed.

Also, when we report account balances in financial statements only at the end of a month,
record-keeping costs can be reduced by making only one adjusting entry at that time. This
entry needs to record the total cost of all supplies used in the month. Therefore Unity
company takes inventory (counting) of the unused supplies. The cost of the remaining
supplies is then deducted from the cost of the purchased supplies to compute the amount used.

Example: Unity Company has Birr 2,670.00 purchased in December. The Birr 1,050.00
difference between these two amounts is the cost of the consumed supplies. This amount is
December’s supplies expense. Our adjusting entry to record this expense and reduce the
supplies asset account is:

Dec. 31 Supplies expense………………………..1,050.00

Supplies…………………………………….1,050.00
(To record the supplies used)
Posting this adjusting entry affects the amounts as follows (using T. account).

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 Supplies

Supplies purchased: Dec, 31. 1,050

Dec. 2, 2,500
Dec. 6, 1100
Dec. 26, 120

Total 3720 Total 1050

-1050

Bal. (Dec.31) 2,670

c. Prepaid Rent:- The accounting treatment for prepaid Rent is also the same as prepaid
Insurance and supplies. When a company pays monthly rent on the first day of each month,
the payment created a prepaid expense on the first day of each month that fully expires by the
end of the month.

d. Depreciation:-
Depreciation:- plant and equipment refers to long-term tangible assets used to produce and
sell products and services. These assets are expected to provide benefits for more than one
period. Example: land, buildings, machines, vehicles, and fixtures. All plant and equipment
assets, except for land, eventually wear out or decline in usefulness. The costs of these assets
are deferred, but gradually reported as expenses in the Income statement over the assets useful
lives (benefit periods). Depreciation is the process of computing expense by allocating the
most cost of these assets over their expected useful lives. Depreciation expense is recorded
with adjusting entry similar to that for prepaid expenses.

Example: Unity Company uses equipment in earning revenue. This equipments cost must be
depreciated. The company purchased two equipment, one for Birr 20,000 and the other for
Birr 6,000,in early Dec. 4,1996 the account expects this equipment to have useful life ( benefit
period) of four years. The company expects to sell the equipment for about Birr 8,000
8,000 at the
end of four years (Residual value). This means the net cost expected to expire over the useful
life is Birr 18,000 (Birr 26,000 – Birr 8,000). There are several methods we can use to
allocate these birr 18,000 net costs to expense Assume Unity company uses a method called

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straight –line depreciation. This method allocates equal amounts of an assets cost to
depreciation during its useful life. When the Birr 18,000 net cost is divided by 48 months
(four years) in the assets useful life, we get on average monthly cost of Birr 375 (Birr
18,000/48). Our adjusting entry to record monthly depreciation expense is :

Dec. 31 Depreciation………………….375

Accumulated Depreciation-equipment…………375

To record monthly depreciation an equipment posting this entry affects the accounts as
follows (using T. account)

Equipment Accumulated Dep.

Dec. 3 ……20,000 Dec. 375

6………6,000
Bal. 26,000

Dep. Expense
Dec.31……375

After posting the adjusting entry, the equipment account loss its accumulated depreciation-
equipment account equals the Dec. 31 Balance sheet amount for this asset. The balance in
depreciation expense (Birr 375) is the expense reported in De4c. 31, Income statement . If
the adjustment is not made at Dec. 31, then (a) expense are under stated by Birr 375 and net
income overstated by Birr 375 for December Income statement . and (b) both assets and
Owner’s equity are over stated by Birr 375 in the December 31, Balance sheet.

1.2.3.2 Unearned Revenues

Unearned revenue refers to cash received in advance of providing products and services.
Unearned revenues, also known as deferred revenues, are a liability when cash is accepted
(received), an obligation to provide products and services is accepted (created). As products
and services are provided, the unearned revenues become earned revenues. Adjusting entries

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for unearned revenues involve increasing (crediting) revenues and decreasing (debiting)
unearned revenues.

Example:
Example: Unity Company agreed on December 26 to provide consulting service to client for
a fixed fee. Birr 1,500.00 per month. On that same day, this client paid the first two months’
fees in advance (covering the period Dec. 27 to fee. 24.). The entry to record the cash
received in advance is:

Dec.26. Cash…………………………… 3,000.00

Unearned consulting revenue……………………..3,000.00

(To record cash received in advance for services over the next two months)

This advance payment increases cash and creates an obligation to do consulting work over
the next two months. As time passes, Unity Company will earn this payment. By Dec.31 .
Unity Company provides five day’ service and earns One – sixth of the Birr 1,500.00 revenue
for the first month (December). This equals to Birr 250.00 ( Birr 1,500.00 X 5/30). The
revenue recognition principle lies that Birr 250 out of unearned revenue is reported as revenue
for December. Income statement.

Adjusting entry to reduce the liability account and recognize earned revenue is.

Dec. 31 Unearned consulting revenue………………..250.00

Consulting Revenue (1,500 X 5/30)…………………..250.00

(To record earned revenue received in advance)

After posting the adjusting entry, the accounts appear as follows: The adjusting entry transfers
Birr 250 out of unearned revenue (a liability account) to a revenue account.

If adjustment is not made, then (a) revenue and net Income are understated by Birr 250 in
December Income statement, and (b) unearned revenue is over stated and owners equity
understated by Birr 250.00 on December 31 Balance sheet.

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 (Balances accounts after adjustment would appears follows)

Unear ned consulting revenue Consulting Revenue

(Adj.)…Dec.31…250 Dec. 26…3000.00 Dec. 31……250

Bal. 31….2750 Bal…………250

Check Your Progress Exercise - 1

1. Prepared expenses are:
a. Paid and recorded in an asset account before they are used or consumed.
b. Paid and recorded in an asset account after they are used or consumed.
c. Incurred but not yet recorded.
d. Incurred and already paid or recorded.
2. Unearned revenues are:
a-recorded and recorded as liabilities before they are earned.
b- earned and recorded as liability before they are received
c- earned but not yet received or recorded
d- earned and already received and recorded.
3. The village laundry company purchased Br. 6,500 worth of laundry supplies on June 2
and recorded the purchase as an asset. On June 30, an inventory of the laundry supplies
indicated only birr 30,000 on hand. The adjusting entry that should be made by the
company:
a. Debit laundry supplied expense br. 3000 credit laundry supplies, Br. 3000
b. Debit Laundry supplies expense Br. 3500 credit raudary supplies, Br. N3,500
c. Debit laudary supplies Br. 3, 500, credit Laudary supplies expense Br. 3, 500
d. Debit laudary expense Br. 3, 500, credit laudary supplies Br. 3, 500

1.3 ACCRUALS

1.3.1. Meaning of Accruals (In General)

Accruals are created by an unrecorded expenses that has been incurred or unrecorded
revenues that has been earned.

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1.3.2. Types of Accruals
Accruals are broadly classified into two: Accrued expenses or accrued liability and accrued
revenues or accrued assets.

1.3.3. Meaning and Accounting Treatment for Accrued Expenses or Accrued

Liabilities

1.3.3.1. Accrued Expenses or Accrued Liabilities: are expenses that have been incurred but
have not been recorded in the accounts. Accrued expenses refer to costs that are incurred in a
period but are both unpaid and unrecorded. Accrued expenses are incurred expenses that must
be reported (recorded) on the Income statement. Such costs are incurred in acquiring products
and services, when a company acquires products and services, an obligation to pay (in future)
for them will be created. Thus, the costs and products and services acquired but not paid are
called accrued expenses. Accrued expenses are liabilities to the company. Why do not
accountants record the accrued expenses when these expenses are incurred? The answer is
because of the inconveniency of recording. For instance, to record the daily wages expenses
would require many entries with small amounts in a journal and managers do not need a day-
to-day information about wages expense. The common examples include accrued wages,
(wages payable) Accrued Interest, (Interest Payable), Notes Payable, Accrued Taxes (taxes
payable)

Adjusting entries for recording accrued expenses (which were not recorded), involves
increasing (debiting) expenses and increasing (crediting) Liabilities. This adjustment
recognizes expenses incurred in the given period but not paid. (The payment would be on the
next period).

Illustration:
Illustration: Unity company’s employee earns Birr 70 per day, or Birr 350 for a five day
workweek beginning on Monday and ending on Friday. This employee gets paid every two
weeks on Friday. December 12, and 26, the wages are paid recorded in the journal, and
posted to the ledger. Unadjusted salaries expenses and cash paid for salaries appear as
follows:

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 Dec. 12. Salary expense…………………..700

Cash……………………………700

Dec. 12. Salary expense…………………..700

Cash…………………………….700
However, the calendar shows three working days for the December 26 pay-day (29,30 and
31). This means the employee earns three days salary by the close of the business on
Wednesday, Dec. 31. while this salary cost has been incurred, It is not yet paid or recorded.
Thus, The compayfails to report both the added expenses and the liability . the year-end
adjustment entry to account for accrued salaries is :

Dec. 31. ..Salaries expenses ……………..210

Salaries payable……………………….210

(To record three day’s accrued salary (3 X Birr 70)

After the adjusting entry is posted, the expense and the liability account appear as follows.

Salary expense Salary Payable

Dec.12……700 Dec.31…..210
26…...700
31…...210

This means Birr 1,610.00 of salaries expense is reported on the income statement and that Birr
210.00 salary payable (Liability) is reported in the Balance sheet. To the adjustment is not
made, then

(a) salaries expense is understated and net income overstated by Birr 210 in the December
income statement and (b) salaries payable is under stated and owner’s equity overstated by
Birr 210 on the Dec. 31 Balance sheet.

1.3.3.2. Accrued Revenues or Accrued Assets:- these are revenues that have earned but have
not been recorded in the accounts. During accounting period some revenues are recorded only

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when cash is received. Thus, at the end of an counting period, there may be Items of revenue
that have been earned but have not been recorded

In such cases, the amount of the revenue should be recorded by debiting asset account and
crediting a revenue account. Because of the dual nature of such accruals, they are called
accrued assets or accrued revenues

Assume that on December 31, 1990, the end of the fiscal year, Unity Company has an Interest
bearing notes receivable. All Interest Income will be collected in 1991, when payments due
on the note. Assume further that the interest earned but not collected as Dec. 31 1990, is birr
200. the entry to record the increase in the amount of interest due (receivable) on the note and
the revenue earned is a follows.

Dec. 31. Interest Receivable…………………..200

Interest Income……………………….200

After the entry had been posted, the interest receivable account will have balance of Birr 200,
which would b e reported as an asset in the balance sheet for Unity Company. This Interest
income would be reported on the income statement.

Example 2. Assume that Unity company signed an agreement with Addis Ababa , company
on Dec. 15. The agreement provides that Unity Company will render computer service to
A.A Co. on the fifteenth of each month at a rate of Birr 20 per hour. As of Dec. 31, the Unity
Company had provided 25 hours service to A.A Company. Although the revenue of birr 500
(25 hours X Birr 20) will be billed and collected in January, Unity Company earned the
revenue in December. The adjusting journal entry and T accounts to record the claim against
the customer (an accounts receivable) and the fees earned in December are shown below.

Dec. 31. Accounts Receivable ……………..500

Fees Earned…………………………500

After posting the adjusting entry, the balance of Accounts Receivable and fees earned would
be

Accounts Receivable Fees Earned

Dec.31 Bal…2,220 Dec.31 unadjusted Birr 16,340

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 (Before Adjust) Dec. 31. (Adj.) 500
Dec.31 (Adj.)…….500
Dec.31 (Adjusted)..2,720 Dec.31 (Adjusted)……..16,840
If the Adjustment for accrued asset (Birr 500.00) is not recorded, fees earned and the net
income will be understated by Birr 200 on the in come statement. On the Balance sheet,
accounts receivable and Owner’s equity will be understated by Birr 500.

Check Your Progress Exercise- 2

1. Accrued Revenues are:

a. Received and recorded as Liabilities before they are earned.
b. Earned and recorded as liability before they are received.
c. Earned but not yet received or recorded
d. Earned and already received and recorded.

2. Accrued Expenses are:

a. Paid and recorded in an asset account before they are used or consumed.
b. Paid and recorded in an asset after they are used or consumed.
c. Incurred but not yet paid or recorded.
d. Incurred and already paid or recorded.

1.4 SUMMARY

After external transactions (Transactions between the company and outsiders) and events are
recorded, several accounts in the ledger need adjusting For correct balances to appear in the
financial statements. This need arises because internal transactions and events remain
unrecorded. The purpose of adjusting accounts of the end of a period is to recognize revenues
earned expenses incurred during the period that are not recorded.

Adjustments can be grouped according to the timing of cash receipts or payments relative to
when they are recognized (recorded) as revenues or expenses. There are five groups: prepaid
expenses, depreciation, unearned revenues, accrued expenses, and accrued revenues.
Adjusting entries are necessary for each of those groups so that revenues, expenses, assets,
and liabilities are correctly reported for each period.

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Accounting adjustments bring an asset or liability account balance to its correct amount.
They also update related expenses and revenue accounts. Every adjusting entry affects one or
more income statements accounts and one or more balance sheet accounts. An adjusting entry
never affects cash. Adjustments are necessary for transactions that extend over move than
one period.

Deferrals: prepaid expense refers to items paid for in advance of receiving their benefits.
Prepaid expenses are assets. As prepaid expenses (asset) is used, its cost becomes an expense.
Adjusting entries for prepaid involves increasing (debiting) expenses and decreasing
(crediting) assets. Unearned (or prepaid) revenues refer cash received in advance of
providing products and services. Unearned revenues are liability. As products and services
are provided, the amount of unearned revenues becomes earned revenues. Adjusting entries
for unearned revenues involve increasing (crediting) revenues and decreasing (debiting)
unearned revenues.

Accrued expenses refer to costs involved in period that are both unpaid and unrecorded.
Adjusting entries for recording accrued expenses involve increasing (debiting ) expenses and
increasing (crediting) liabilities. Accrued revenues refer to revenues earned in a period that
are both unrecorded and not yet received in cash. Adjusting entries for recording accrued
revenues involve in creasing (debiting) assets and increasing (crediting) revenues.

1.5 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise - 1

1. A (2) A (3) D

Check Your Progress Exercise - 2

1. C
2. C

1.6 GLOSSARY

1. Accrued assets and Liabilities- Assets and liabilities that exist at the end of an
accounting period but have not yet been recorded, they represent rights to receive, or

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 obligations to make, payment that are not legally due at the balance sheet date. Examples
are accrued fees- receivable, salaries payable.

2. Accrued Revenue and Expenses-other

Expenses-other names for accrued assets and Liabilities.

3. Accrual Basis of Accounting-

Accounting- Recognize revenues when sales are made or services
are performed, regardless and when cash is received. Recognizes expenses as incurred.
(enter into an obligation), whether or not cash has been paid out.

4. Deterred Items-
Items- Adjusting entries involving data previously recorded in accounts –
data are transferred from asset and liability accounts to expenses and revenue accounts.
Examples are prepaid expenses, depreciation, and unearned revenues.

5. Unearned Revenue – Assets received from customers before services are performed
for them. Since full revenue has not been earned, it is a liability, often called revenue
received in advance or advances by customers.

6. Useful Life – Estimated number of time periods that a company can take use of the
asset.
7. Adjusting Entries – journal entries made at the end of an accounting period to bring
about a proper matching of revenues and expenses; reflect economic activity that has
taken place but has not yet been recorded. Adjusting entries are made to bring the
accounts to their proper balances before financial statements are prepared.

8. Cash Basis of Accounting –Recognizes revenues when cash is received and

recognizes expenses when cash is paid out.

9. Matching Principle – Accounting principle requiring that expenses in producing

revenues be deducted from the revenues they generated during the given accounting
period.

10. Salvage Value (scrap – values) - the amount that can be obtained from assets. The
future services that assets can render make assets “things of value” to a business.

1.7 MODEL EXAMINATION QUESTIONS

1. The trial balance of Unity company for December, 31, 1991. Includes, among other

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 items, the following account balances.

Debits Credits
Office supplies on hand …………………Birr ….6000
Prepaid rent………………………………Birr...25,200
Buildings…………………………………Birr. 200,000
Accumulated depreciation-building…………………………….Birr 33,250
Salaries expense………………………….Birr 124,000
Unearned delivery fees………………………………………….Birr….4,000

Additional Data:
1. Part of the supplies represented by the birr, 6000 balance of the office supplies on land
account have been consumed. An inventory count of the supplies actually on hand at
Dec.31 totaled to Birr 2,400.00.
2. On May 1 of the current year, a rental payment of Birr 25,200.00 was made for 12
months of rent, it was debited to prepaid rent.
3. The annual depreciation for the building s account less an estimated salvage value of
Birr 10,000.00. the estimated useful lives of the buildings are 40 years each.
4. The salaries expense of Birr, 124,000.00 does not include birr 6,000.00 of unpaid
salaries earned since the last payday.
5. One fourth of the unearned delivery fees have been earned by Dec. 31
6. Delivery services of birr 600.00 were performed for customer, but a bill has not yet
been sent.

Required:
a) prepare the adjusting journal entries for December 31, assuming adjusting
entries are prepared only of year-end
b) based on the adjusted balances shown in the accumulated depreciation-
building account, how many years has Unity Company owned the building

Additional to Model Examination

1. Abebe is a barber who does his own accounting for his shop. When he buys supplies
he routinely debits supplies. Abebe purchased Br. 1, 500 supplie4s in Jan. and his

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 inventory at the end of Jan. shows Br. 600 of supplies remaining. What Adjusting entry
should be Abebe make on Jan 31.2

2. Atalay is a lawer who requires that his clients pay him inadvance of legal services
rendered. Atalay routinely credits legal fees earned when his clients pay him in advance.
In June. Atalay collected Br. 8, 000 in advance fees and completed 75% of the work
related to these fees. What adjusting entry is required by Atalay’s firm at the end of June?

1.8 REFERENCE BOOKS

1. Fundamental Accounting Principles, Fifth ed., Kernit D. Larson, John J. wild, Barbar.
Chiappetta, 1999.

2. Accounting principles, Fess, Warren, 16th Ed.

3. Roger. H. Hermanson James D. Edwards and R.F. Salmonson, 1989 Accounting

Principles.

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