Accounting for Deferrals (Lecture 3)
In this free online accounting lesson we define deferrals and accounting allocation. We then provide an example of allocation which incorporates definition of salvage value. After that we move on to unearned revenue and revenue recognition. Following that we discuss historical cost, book (carrying) value of fixed asset and depreciation expense. Finally, we talk about prepayments (prepaid expenses) like prepaid insurance and how to account for it, and get familiar with accounting for supplies. Accounting examples are provided for most learning objectives.
Accruals are defined as recognition of revenue or expenses before cash is received or paid. However, accrual accounting does not only relate to events with cash moving afterwards, but also to situations with cash moving before recognition of revenue or expenses.
A deferral refers to recognition of revenues or expenses at some time after cash has been transferred.
To make it clear, let us stop on definitions of accruals and deferrals again. Accruals refer to recognition of events before cash flows. Deferrals pertain to recognition of events after cash flows.
Illustration 3-1: Accruals and deferrals differences
Sometimes deferred amounts are spread over a period of time and their recognition in the income statement is being made proportionally to time passed. Such situations create a need for allocations.
Allocation is a process of assigning a portion of an entire amount to each of several accounting periods.
3.1 Illustration #1 for accounting for deferrals
We will take a closer look at deferrals using an example.
Mrs. Piksvel decided to open a business. For this purpose on May 25, 20X7 she made a capital contribution of $4,400. The company was called SuperDels and mainly provided delivery services for corporate clients. On June 31, 20X7 SuperDels signed a contract with a local publishing company and received $3,000 as an advance payment for delivery services to be provided during the following 12 months. These services will be conducted within a year from June 31, 20X7, so they will have a continuing basis. To meet the client's expectations for high quality and timely services, Mrs. Piksvel bought a car costing $4,000 with a salvage value (see below for the definition) of $500. It is estimated that the car will be in use for 5 years. SuperDels incurred $300 of expenses in 20X7 and paid them with cash. In addition, Mrs. Piksvel had invested $1,000 into land. Summary of all transactions is presented below:
- Owner made a $4,400 capital contribution.
- SuperDels collected $3,000 cash in advance for services to be performed between June 31, 20X7 and July 1, 20X8.
- SuperDels purchased a car for $4,000 with a salvage value of $500 and 5-year useful life.
- $1,000 was invested in land.
- SuperDels incurred and paid operating expenses of $300.
- An adjusting entry is required to recognize revenue earned in 20X7.
- An adjusting entry is required to recognize expense incurred in 20X7 associated with the car use.
Let us see what effects the transactions above will have on the accounting equation and financial records.
3.1.1 Analysis of capital contribution transaction
1) The capital contribution of $4,400 is an asset source transaction and we already know effects of such transactions:
Illustration 3-2: Effect of capital contribution
|
Assets |
... |
Equity |
|
Cash |
... |
Contributed Capital |
Beginning Balances |
$ 0 |
|
$ 0 |
1) Capital Contribution |
+4,400 |
|
+4,400 |
Ending Balances |
4,400 |
|
4,400 |
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