5 Revenue Recognition and Accruals

Accrued Liabilities.

Prepaid expenses are on the asset side. What about accruals on the liability side? Great question! There are indeed accrued liabilities. On the liability side, you will see the words accrual or payable. For example, accrued salaries is also called salaries payable; and accrued interest is called interest payable. In this chapter we will concentrate on salaries payable. Interest payable is covered in Chapter 12: Debt and LeverageLeverage:
The portion of capital in the company that comes from debt sources. Highly leveraged companies have high levels of debt compared to equity. Commonly evaluated using the debt-to-equity ratio. Also called gearing..

Employees work for a company in exchange for a paycheque. Payment schedules depend on the company. Employees may be paid monthly, bi-weekly, semi-monthly, or even weekly. What happens if employees work for a company, making inventory or performing services, but have not been compensated at the end of a period? There are two issues here. First, the company has to record that they owe employees cash: an accrued liability called salaries payable. Let’s make sure that salaries payable meets the liability criteria:

Present Obligation?A Liability is a Present Obligation.
The company owes something now—even if they aren’t going to pay until later.

Yes. The company owes employees for hours worked, even if the payroll period has not ended. You can think about it this way: if an employee quit their job before the payroll period ended, the company would have to pay their wages. A company has to honour employment contracts and pay employees for all time worked.

Arising from Past Events?A Liability Arises from a Past Event.
There are many possible past events that lead to a present obligation. Employees having worked and expect to be paid for that time is one of those possibilities!

Yes. The employees worked for us – a past event.

Resulting in an Outflow of Economic Resources?A Liability is Expected to Result in an Outflow of the Entity’s Resources.
Usually (but not always), this means the company will pay out cash: the employees’ regular paycheques!

Yes. The company expects to pay cash to their employees at the end of the payroll period.

So salaries payable meets the liability criteria. As a liability, the balance of salaries payable goes up with a credit. Companies may make this accrual entry at month- or quarter-end, but it is necessary at the fiscal year end. All companies account for accrued liabilities at the fiscal year end.

But what account is debited? This leads us to the second issue. Employees create value through their labour efforts. If this is true: employee salaries and wages allow companies to generate revenue, then these costs should be expensed in the same period as the revenue is recognized. That means that the debit is an expense: salaries expense.

My Turn:

Company D employees are paid biweekly. At the company’s fiscal year end of 31 December, Company D estimates that employees are owed $12,000 for time worked in the current pay period. Prepare the journal entry to accrue salaries at 31 December.

31 December:

Your turn to practice!

And another one for fun!

Amazing; you’re doing great. Almost there!

When the pay period ends, employees get paid. A company will credit cash for the amount paid to employees, then reduce the balance of salaries payable to reflect that the company has paid their obligation with cash. The extra debit needed to balance this transaction is payment for work after the liability was accrued.

My Turn:

Company D receives employee timecards for the biweekly payroll run on 04 January, totaling $16,000, and pays employees on the same day. Remember that Company D accrued salaries of $12,000 on 31 December. Record this payment for salaries.

Your turn to practice!

And another one for fun!

Well done! You know so much about the Income Statement. If you want to know more about payroll deductions and liabilities, head to the appendix – 5A: Payroll Deductions and Liabilities. Otherwise, we will further explore how the Income Statement links to the Statement of Financial Position. See you in the next chapter where we will build Statements of Changes in Equity!