Equipment, When a company purchases an asset that will be used for more than one ac- counting period, the cost of the asset is not recognized as an expense when the asset is pur- chased. The expense of using the asset is recognized during the periods in which the asset is used to generate revenue. When a firm buys an asset-such as a computer or office fur- niture-it will record the purchase as an asset. It is an asset exchange because the flrm is exchanging one asset-cash-for another asset-equipment. Then, the hrm will recognize
March
C H A P T E R 3 . DEFERRALS 111 a portion of that equipment cost each accounting period in which the equipment is used,
hopefully to generate revenue.
The matching principle is the reason the cost of equipment is spread over several peri- ods. Expenses and the revenues they help generate need to be on the same income state- ment-that is the heart of the matching principle. When it is hard to make a precise match with specific revenue (such as sales and cost of goods sold), the next best match is to put an expense on the income statement in the period in which the related asset is used. That is what you do with equipment-allocate the cost of the equipment to the periods the equip- ment is used.
Suppose a company purchases a computer for $5,000 cash. When the purchase is made, the company will record the acquisition of the new asset and the cash payment.
Assets Liabilities + Shareholder's equity
Contributed + Retained capital earnings (5,000) cash
+ 5,000 computer
If the firm were to classify the purchase as an expense at this point, it would be doing a very poorjob of matching revenues and expenses. The firm wants to recognize the expense of the computer during the years in which it uses the computer.
The terminology that accountants use with equipment is different than the terminology used with other deferrals. Instead of calling the expense related to using the computer some- thing logical like "computer expense," it is called depreciation expense. Do not confuse depreciation in this accounting context with depreciation commonly used to mean decline in market value.
As the asset is used and the firm wants to reduce its amount in the accounting records, the accountant will not subtract the amount of the expense directly from the asset's purchase price. Instead, per GAAP, the firm will show the subtractions separately on the balance sheet. Exhibit 3.8 shows how Best Buy Co. Inc. presents this information.
Using real financial information to first learn an accounting concept can be difficult.
An example with a fictitious company will help explain the accounting treatment of the cost of equipment and its depreciation expense over time. Sample Company purchased the com- puter for $5,000 on January l, 2009, and recorded the asset exchange shown in the preced- ing accounting equation. Then, when Sample Company prepares its year-end financial statements, depreciation expense must be recognized. The shareholders' claims to the com- pany assets are reduced via depreciation expense.
To calculate how much the asset cost should be reduced each year, Sample Com- pany first must deduct the value it believes the asset will have-what it will be worth- when the company is finished using it. That amount is called the residual value. In this example, Sample Company plans to use the computer until it is worth nothing; that means the residual value is zero. The cost of the asset minus any residual value is di- vided by the number of accounting periods that the asset will be used. Usually, the time period for depreciation expense is a year. Because Sample plans to use the $5,000 com- puter for 5 years and has estimated its residual value to be zero, the annual depreciation amount will be $1,000.
The total reduction in the dollar amount of equipment, at any particular point in time, is called accumulated depreciation. Each year, accumulated depreciation gets larger. Ac- cumulated depreciation is not the same as depreciation expense. Accumulated depreciation is the total depreciation taken over the entire life of the asset, and depreciation expense is the amount of depreciation for a single year. Accumulated depreciation is called a contra- asset because it is the opposite of an asset. It is a deduction from assets. Accumulated de- preciation is disclosed separately somewhere in the financial statements so that the original cost of the equipment is kept intact.
On the balance sheet, the original cost of the equipment is shown along with the de- duction for accumulated depreciation-the total amount of depreciation that has been
The depreciation expense is the expense for each period.
Residual value, also known as salvage value, is the estimated value of an asset at the end of its useful life. With most depreciation methods, residual value is deducted before the calculation of depreciation expense.
The accumulated depreciation is the reduction to the cost of the asset. Accumulated depreciation is a contra-asset, deducted from the cost of the asset for the balance sheet.
A contra-asset is an amount that is deducted from an
1 1 2 C H A P T E R 3 . A C C R U A L S A N D D E F E R R A L S : T I M I N G l S E V E R Y T H I N G l N A C C O U N T I N G
E X H I B I T 3 . 8
Assets from Best Buy's Balance Sheet
Best Buy has property and equipment that cost $4,836 million on February 25,2006.
The total amount of depreciation expense the firm has recorded over the life of these assets is
$2.124 million.
Best Buy Co., Inc.
Consolidated Balance Sheets
($ in millions)
February 25, February 26,
2006 2005
Assets Current Assets
Cash and cash equivalents . . . . Short-term investments
Receivables
Merchandise inventories Other current assets
Total current assets Property and equipment
Land and buildings Leasehold improvements
Tladename
Long-term investiments Other assets
Tota] assets
$ 681 3,051
506 3,338
409
$ 354 2,994 2,851 329 7,985
580 r,325
6,903 506 1,139
557 44 2t8 348
$ 11,864
2,898 2,458
33 89
5 1 3 40 148 226
$ 10,294
The book value of an asset is the cost minus the
accumulated depreciation related to the asset.
Carrying value is another expression for book value.
recorded during the time the asset has been owned. The resulting amount is called the book value, or carrying value, of the equipment. The book value is the net amount that is in- cluded when the total assets are added up on the balance sheet.
Here is the year-end adjustment to record depreciation of the asset after its first year of use:
Assets Liabilities Shareholder's
Contributed + capital
Retained earnings (1,000)
accumulated
(1,000)
depreciation
depreciation expense
The accumulated depreciation is shown on the balance sheet as a deduction from the cost of the equipment. The depreciation expense is shown on the income statement. The book value of the asset is $4,000 (cost minus accumulated depreciation) at the end of the first year.
After the second year of use, Sample Company would again record the same thing-
$1,000 more recorded as accumulated depreciation and $1,000 as depreciation expense.
The amount of accumulated depreciation will then be $2,000. The amount of depreciation expense is only $1,000 because it represents only a single year-the second year-of de- preciation expense. The accumulated depreciation refers to all the depreciation expense for the life of the asset through the year of the financial statement. The book value of the com- puter at the end of the second year is $3,000-$5,000 cost minus its $2,000 accumulated deoreciation. See Exhibit 3.9 for another example.
Goodwill
Cost of the truck will be soread over the income statements of the seven years the truck is used as depreciation expense.The expense is being deferred,thalis put off, until the truck is actually used.
C H A P T E R 3 . E F F E C T S O F A C C R U A L S A N D D E F E R R A L S O N F I N A N C I A L S T A T E M E N T S 1 1 3 Truck ourchased on
J a n u a r y 1 , 2 0 0 7 . T h e truck will last for seven years. Cost is $49,000.
No residual value.
E X H I B I T 3 . 9
The cost of the assef is spread-as an expens#venly (in this example) over the life of the asset.
Year ended December 31 Depreciation expense Accumulated deoreciation
gs q'-@ 6*@ &slffi Wt& q5--t@ Sts$
2007 2008 2009
$ 7 , 0 0 0 $ 7 , 0 0 0 $ 7 , 0 0 0
$7,000 $14,000 $21 ,000
2010 2011 2012 2013
$ 7,000 $ 7,000 $ 7,000 $ 7,000
$28,ooo $35,000 $42,000 $49,000
Deferred Expenses- D e p r e c i a t i o n
Tango Company purchased a computer on July 1,2006, for $5,500. lt is expected to last for 5 years and have a residual value of $500 at the end of the fifth year. How much depreciation expense would appear on the Tango December 31,2006, income statement? What is the book value of the computer at the end of 2OO7?
Effects of Accruals and Deferrals on Financial Statements
Now that you have learned the details of accrual and deferrals you are ready to put it all to- gether in the construction of a set of financial statements. We will take Tom's Wear through its third month of business to see how timing differences affect the firm's financial state- ments. Then we will look at some real firms' financial statements to identify the effects of accruals and deferrals.
Tom's Wear Transactions for March
In Chapters I and2, Tom's Wear completed its first two months of operations. Exhibit 3.10 shows the company's balance sheet at the end of the second month, which we prepared in Chapter 2.
Tom's Wear, Inc.
Balance Sheet At February 28,2006
Liabilities and Shareholder's equity
Your Turn 3-6
WnWru,P-W .ffi**q#-,W-m
I-.$.4
C o n s t r u c t t h e b a s i c f i n a n c i a l statements from a given set o f t r a n s a c t i o n s t h a t i n c l u d e a c c r u a l s a n d d e f e r r a l s a n d recognize the effect of these transactions on actual financial statements.
E X H t B t T 3 . 1 0
Tom's Wear Balance Sheet at February 28,2006
t0m'sweal
Cash
Accounts receivable Inventory
Prepaid insurance
A c c o u n t s p a y a b l e . . . $ O t h e r p a y a b l e s . . . .
Common stock Retained earnings Total liabilities and
shareholder's equlty .
$ 6,695 150 100 125
800 50 5,000 r,220
$ 7,070 T o t a l a s s e t s . . . $ 7 , 0 7 0
1 1 4 C H A P T E R 3 .
E X H I B I T 3 . " I 1
A C C R U A L S A N D D E F E R R A L S : T I M I N G l S E V E R Y T H I N G l N A C C O U N T I N G
T r a n s a c t i o n s f o r M a r c h 2006 for Tom's Wear
l March I
2 March 10 3 March 15 4March20 5March24 6March27
Purchased computer for $4,000 with $1,000 down and a 3-month, l2o/onote for $3,000. The computer is expected to last for 3 years and have a residual value of $400.
Paid the rest of last month's advertising biII, $50.
Collected accounts receivable of $150 from customers from February.
Paid for February purchases-pa)"ng off the accounts payable balance of $800.
Purchased 250 shirts @ $4 each for cash, $1,000.
SoId 200 shirts for $10 each, all on account, for total sales of $2,000.
These are the amounts that are carried over to the next month, so this is the March I,2006, balance sheet, too. We will now take Tom's Wear through the third month of business, with the transactions shown in Exhibit 3.11.
At the end of his third month, Tom prepares his financial statements to see how his business is progressing. We will see how each transaction affects the accounting equation.
Then, look at the accounting equation worksheet in Exhibit 3.12 at the end of the example to see all ofthe transactions together.
Transaction l: Purchase of a long-term assel Tom's Wear purchases a fixed asset that will last longer than 1 year; therefore, it will be classified as a long-term asset. Re- member, current assets will be used up or converted to cash within 1 year. If the cost of an asset needs to be spread over more than 1 year, it is considered long term.
The actual purchase of the asset is recorded as an asset exchange, not as an ex- pense. Do not wolry about depreciation expense and interest expense right now.
That will be considered when it is time to prepare the financial statements. Here is how the purchase of the $4,000 computer with $1,000 down and a note payable of
$3.000 with an annual interest rate of l2Vo, dte in 3 months. affects the account- ing equation:
Assets Liabilities + Shareholder's equity Contributed +
capital
Retained earnings (1,000) cash
+ 4,000 computer
* 3,000 notes payable
The recognition of the expense related to the cost of the computer will be deferred- put off-until Tom's Wear has used the asset and is ready to prepare frnancial state- ments. The cash portion of the payment for the computer will be shown as an investing cash flow on the statement of cash flows.
Transaction 2: Cash disbursement to settle a liability Last month, Tom hired a com- pany to do some advertising for his business. On February 28,2006, Tom's Wear had not paid the full amount. Because the work was done in February, the expense was shown on the income statement for the month of February. In March, Tom's Wear pays cash of $50 to settle-eliminate-the liability. Here is how the cash dis- bursement affects the accounting equation:
Assets Liabilities + Shareholder's equity
Contributed + capital
Retained earnings (50)
cash
(50) other payables
The action took place during February, so the expense was shown on that month's in- come statement. The cash is now paid in March, but no expense is recognized in
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1 1 6 C H A P T E R 3 . A C C R U A L S A N D D E F E R R A L S : T I M I N G 1 5 E V E R Y T H I N G l N A C C O U N T I N G
March because that would be double counting the expense. An expense is recog- nized only once. The cash payment is an operating cash flow for the statement of cash flows.
Transaction 3: Collection of cash to settle a receivable At the end of last month, Tom's Wear had not received all the cash it was owed by customers. Because the sales were made during February, the revenue from those sales was shown on the income state- ment for the month of February. Because the cash for the sales was not collected at the time the sales were made, Tom's Wear recorded accounts receivable. Accounts receivable is an asset that will be converted to cash within the next year. When cus- tomers pay their bills, Tom's Wear records the receipt of cash and removes the re- ceivable from its records. Here is how the collection of the cash affects the accounting equation:
Assets = Liabilities + Shareholder's equity Contributed +
capital
Retained earnings
* 150 cash (150) accounts
receivable
Revenue is not recorded when the cash is collected because the revenue was already recorded at the time of the sale. To count it now would be double counting. The cash collection is an operating cash flow for the statement of cash flows.
Transaction 4: Payment to vendor Atthe end of last month, the balance sheet for Tom's Wear showed accounts payable of $800. This is the amount still owed to vendors for February purchases. Tom's Wear pays this debt, bringing the accounts payable bal- ance to zero. The cash payment is an operating cash flow for the statement ofcash flows.
Assets Liabilities Shareholder's equity
Contributed + capital
Retained earnings (800) cash (800) accounts
payable
Transaction 5: Purchase of inventory Tom's Wear purchases 250 shirts at $4 each, for a total of $1,000 and pays cash for the purchase. The cash payment is an operating cash flow for the statement of cash flows.
Assets Liabilities + Shareholder's equity Contributed +
capital
Retained earnings (1,000) cash
+ 1,000inventory
Transaction 6: Sales Tom's Wear sells means the company extended credit later.
200 shirts at $10 each. all on account. That to its customers and Tom's Wear will collect Assets Liabilities + Shareholder's equity
Contributed + capital
Retained earnings + 2,000 accounts
receivable
-l 2,000 sales revenue
At the same time sales revenue is recorded, Tom's Wear records the reduction in inven- tory. The reduction in inventory is an expense called cost of goods sold.
Assets
C H A P T E R 3 . E F F E C T S O F A C C R U A L S A N D D E F E R R A L S O N F I N A N C I A L S T A T E M E N T S 1 1 7
Liabilities + Shareholder's equity Contributed *
capital
Retained earnings
(800) inventory (800) cost of
goods sold Notice that the sale is recorded at the amount Tom's Wear will collect from the customer. At the same time, the reduction in the inventory is recorded at the cost of the inventory-2}O shirts at a cost of $4 per shirt. This is a terrifrc example of the matching principle.
Notice that there is no explicit recording of profit in the company records. Instead, profit is a derived amount; it is calculated by subtracting cost of goods sold from the amount of sales. For this sale, the profit is $1,200. It is called the gross profit-also called gross margin-on sales. Other expenses must be subtracted from the gross margin to get to net proht, also called net income.
Up to this point, we have looked just at the routine transactions during the month ended March 3I, 2006. At the end of the month, Tom's Wear will adjust the company records for any accruals and deferrals needed for accurate financial statements. Look back over the transactions and see if you can identify the adjustments needed.
Adjustments to the Accounting Records
A review of the transactions for March should reveal three adiustments needed at the end of March 2006:
1. Depreciation expense for the computer 2. Insurance expense for the month 3. Interest expense on the note payable
We will now look at each of the adiustments and how the amounts for those adiustments are calculated.
Adjustment 1: Depreciation The computer purchased on March 1 must be depreci- ated-that is, part of the cost must be recognized as depreciation expense during March. To figure out the depreciation expense, the residual value is subtracted from the cost of the asset, and then the difference is divided by the estimated useful life ofthe asset. In this case, the residual value is $400, so that amount is subtracted from the cost of $4,000. The remaining $3,600 is divided by 3 years, resulting in a depre- ciation expense of $1,200 per year. Because we a"re preparing monthly statements, the annual amount must be divided by 12 months, giving $100 depreciation per month. The adjustment is a reduction to assets and an expense.
Assets = Liabilities + Shareholder's equity Contributed * Retained
capital earmngs
(100)
accumulated depreciation
(100)
depreciation expense The reduction to the cost of the computer accumulates each month, so that the carry-
ing value of the asset in the accounting records goes down by $100 each month. In the accounting records, we do not simply subtract $100 each month from the com- puter's cost on the left side of the equation, because GAAP requires the cost of a specif,tc asset and the total accumulated depreciation related to that asset to be shown separately.
The subtracted amount is called accumulated depreciation. After the first month, ac- cumulated depreciation related to this particular asset is $100. After the second month, the accumulated depreciation will be $200. That amount-representing how
N o t i c e , t h e r e s i d u a l v a l u e is d e d u c t e d o n l y i n t h e c a l c u l a t i o n o f t h e a m o u n t of depreciation expense. lt is not deducted from the cost of the asset in the company's formal records.
1 1 8 C H A P T E R 3 . A C C R U A L S A N D D E F E R R A L S : T I M I N G 1 5 E V E R Y T H I N G I N A C C O U N T I N G
much of the asset cost we count as used-is a contra-asset, because it reduces the recorded value of an asset.
The cost of an asset minus its accumulated depreciation is called the book value or carrying value of the asset. Each time depreciation expense is recorded, the accu- mulated depreciation increases, and the book value ofthe asset decreases.
Depreciation expense represents a single period's expense and is shown on the income statement.
Adjustment 2: Insurance expense In mid-February, Tom's Wear purchased 3 months' worth of insurance for $150, which is $50 per month. On the March 1 balance sheet, there is a current asset called prepaid insurance in the amount of $125. A full month of insurance expense needs to be recorded for the month of March. That amount will be deducted from prepaid insurance.
Assets = Liabilities + Shareholder's equity Contributed +
capital
Retained earnings (50) prepaid
insurance
(50) insurance expense Notice that the calculation
of the interest expense does not take into
consideration the length of the note. The interest expense would be the same if this were a 6-month note or a Z-year note, or a note of any other length of time.
Interest expense is calculated based on the time that has passed as a fraction of a year because the interest rate used is an a n n u a l r a t e .
Adjustment 3: Accruing interest expense On March 1, Tom's Wear signed a 3-month note for $3,000. The note carries an interest rate of l2%o. (Interest rates are typically given as an annual rate.) Because the firm is preparing a monthly income statement, it needs to accrue 1 month of interest expense. The interest rate formula-Interest : Principal x Rate x Time-produces the following interest computation:
Interest = $3,000 x 0.12 x l/12 (l month out of 12) : $30
Assets Liabilities Shareholder's equity
Contributed + capital
Retained earnings
* 30 interest payable
(30) interest expense These are the needed adjustments at March 3I,2006, for Tom's Wear to produce accurate financial statements according to GAAP.
Exhibit 3.12 shows all of the transactions and adjustments in the accounting equation worksheet. Notice how each financial statement is derived from the transactions.
Preparing the Financial Statements
First, Tom's Wear prepares the income statement. Revenues and expenses are found in the red-boxed columns of the accounting equation worksheet. Organizedard summarized, they produce the income statement for Tom's Wear for March, shown in Exhibit 3.13. The in- come statement covers a period of time-in this case, it covers I month of business activity.
Second, Tom's Wear prepares the statement of changes in shareholder's equity-a summary of what has happened to equity during the period. It is shown in Exhibit 3.l4.L1ke the income statement, the statement of changes in shareholder's equity covers a period of time-here, 1 month.
Third, Tom's Wear prepares the balance sheet-composed of three sections: assets, li- abilities, and shareholder's equity, with the amount of each on the last day of the period.
The assets are arranged in order of liquidity-how easily the asset can be converted to cash.
Current assets will be used or converted to cash sometime during the next fiscal year. Long- term assets will last longer than 1 year.
Current liabilities are obligations that will be satisfied in the next fiscal year. Long-term liabilities are obligations that will not be repaid in the next fiscal year.
Shareholder's equity is shown in two parts----contributed capital and retained earnings. Be- cause the balance sheet is a summary of all the transactions in the accounting equation, it should balance if there are no errors in your worksheet. The balance sheet is shown in Exhibit 3.15.