5 Revenue Recognition and Accruals

Accrued Expenses

The word accrual just means accumulation. In accounting, accrued expenses describes accumulating costs of generating revenues, regardless of whether the cost has been settled in cash. This idea comes up because of the periodicity problem we touched on earlier: a company’s life is split into fiscal years. These fiscal year-end cut-offs mean that the costs of doing business don’t always line up with cash payments. So before a company finalizes its financial statements, whether that be at the end of the year, quarter or month, the company must record accrual entries. Actually, you’ve already recorded accruals without thinking about it. Look at accounts payable. A/P is set up when a company makes a purchase without paying cash to the supplier: cash doesn’t match up with the purchase.

Revenue recognition is also accrual accounting. You’ve practiced on the revenue side with accounts receivable and unearned revenue. In this section we’re shifting focus from revenue to costs. The general rules of accruals are:

• revenue is recognized when it is earned, and
• expenses are recognized when they are used.

Sounds simple, right? Let’s look at a couple accrual examples to see how this works.

Prepaid Expenses

are costs paid in advance for products or services that a company has not used. Examples include rent, car insurance, building insurance, and prepaid telephone. Prepaid expenses is a current asset account that holds these costs until the company has used up the benefits. For example, a company pays $120,000 to rent a building for a full calendar year – 01 January to 31 December. At 01 January, the company pays $120,000, but it has not benefitted from use of the building.

01 January:

Before we continue with journal entries, let’s check to make sure that prepaid expenses meet the asset criteria:

Controlled by the Company?An Asset is Controlled by the Entity.
If a company doesn’t control something, it’s not really theirs. So an asset might be a bank account, land, or a truck—something where there is paperwork showing that it belongs to the company. Or maybe there’s no paperwork but the company has physical control over the asset. In this case, it is clear that we control the building because we do have paperwork stating just that!

Yes. The rental agreement allows the company access to, and control of, the building over the period of one year.

Resulting from a Past Event?An Asset Results from a Past Event.
The most common past event is that a company purchased a resource, which is what happened here!

Yes. A contract was signed, and payment was made in accordance with the contract.

Future Economic Benefit?An Asset will Bring Future Economic Benefits to the Entity.
For example, investments get interest, we sell our T-shirts for more than we bough them (profit), or—in this situation—we use our warehouse to store T-shirts until we need them.

Yes. In this example the company benefits from use of a building

Excellent. It looks like prepaid rent meets the asset recognition criteria!

As time goes on, the company benefits from use of the rental building. Perhaps the company uses the building as a warehouse, or office space. Maybe the company uses it as a sales floor or showroom. In any case, the company needs to record that rent is no longer a future benefit because the benefit is used up over time. But the company was able to generate value by using the building. Sounds like we have a decrease in prepaid expenses because of use, and an increase in rent expense as rent is used to generate revenue. We will record this journal entry at the end of every month starting 31 January and ending 31 December:

31 January:

My Turn:

CompanyA pays insurance on their delivery vehicle. The insurance cost is $3,300 for the year ended 31 August 20X2 and was paid on 01 September 20X1.

Required:

Record the payment of insurance on 01 September, and insurance use over the period 01 September to 31 August.

01 September:

30 September:

This 30 September journal entry will repeat at the end of each month until 31 August 20X2 when the balance of prepaid expenses—insurance is zero.

Now you try!

And one more just for fun!

Great work!!