Study: Deferred Expenses: Cash is Paid BEFORE Expense is Recognized
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Slides 1-3 (2m:51s)
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Slide 1
Welcome to Introduction to Accounting Preparing for a User’s Perspective Deferred Expenses: Cash is paid BEFORE the expense is recognized.
Slide 2
If you recall from the accrual accounting video I introduced the matching principle. The matching principle effectively says that you should recognize expenses in the same accounting period as the revenues that they helped generate. Imagine this here represents an accounting period, let’s say it represents a year. What we should do is when we incur revenues such as sales revenues we should also recognize the related expenses that helped to generate those sales revenues.
For example the cost of the goods sold, the wages expense, the utilities expense, and the advertising expense. All of these are costs that we incurred that helped us to generate these revenues since we’ve received the benefits of these costs we need to expense them so that the revenues and expenses are in the same accounting period.
Consulting revenues. Some related expenses might be salary expense, travel expense, meals and entertainment expense.
Interest income for a bank. One of the key related expenses for a bank that helps to generate interest income is their interest expense.
Rent revenues. Some of their related expenses to a landlord of generating rent revenues are the maintenance fees as well as depreciation expense. This simply represents a spreading of the depreciable cost of the building over the many years that the building will provide benefits.
Insurance premiums for an insurance company. Some of the key expenses for an insurance company are the claims incurred and the benefits provided, so if they have to pay to rebuild someone’s home because it burned down in a fire that would be an expense called claims incurred.
Now let’s go back to this idea of when the cash flows. If the cash for these expenses were to be paid out in the same period as the benefit received that would be a perfect match and you wouldn’t have to worry about deferred expenses or accrued expenses, but when cash is paid out before the benefit is received then that actually generates an asset usually a pre-paid expense of some kind or it could be inventory because we bought inventory and then we’re going to sell it and expense it later. Another one might be a building we paid for the building now but were going to be expensing it over the future as we receive the benefit of that building. Now if we pay after the fact, so we received the benefit of these expenses in this period, but we pay later that would generate a liability that being an accrued expense for example or some type of payable.
Slide 3
Three common matching principles situation that we just talked about but the one that we are going to focus on in this topic is when cash is paid BEFORE the benefit is received and the expense is recognized. These are deferred expenses.
Slides 4-6 (3m:08s)
Links to an external site.Slide 4
Example: on November first X1, Renter Co. paid $18,000 of cash to Landlord Co. for the following 18 month rental period to end on April 30, X3. Record all required entries AND adjusting entries for Renter Co. from 20X1-20X3 as per the matching principle. Per the matching principle, when should the rent expense be recognized?
Let’s diagram it out. On November 1st the payment of $18,000was made, and it’s to cover a rental period that will go into April 30th 20X3, $18,000 for 18 months of rent, that will be $1,000 per month. I’ve created 18 $1,000 payments here to represent the pre-paid rent expense of $18,000. The first two months that are in X1, that will be $2,000 that should be expensed. Then in X2 it’s 12 months for $12,000 and then in X3 it’s 4 months for $4,000. The pre-paid rent expense has now been used up.
Slide 5
Let’s look at the Journal entries on November first X1 we credit cash $18,000 showing that cash reduced. The question is do we recognize an expense now or are we paying for something and we will receive the benefit later? The answer is we are paying for a benefit to be received in the future; therefore, we cannot record this as an expense but rather we will record it as an asset called pre-paid rent expense. Pre-paid rent expense is debited $18,000.
Let’s update the ledger account down below by debiting that $18,000. As of the end of the year we’ve actually received $2,000 worth of benefit we need to debit rent expense $2,000 and reduce the asset pre-paid rent expense by crediting it $2,000. By posting that into the ledger we now have a credit of $2,000 and the new balance of our pre-paid rent expense is $16,000. This asset is being used up and as it is being used up we record the related expense. We now start the year X2 with $16,000of pre-paid rent expense which will then use up a little more.
On 12/31/X2 we say “wow” we still show that we have $16,000 of pre-paid rent, but we’ve used up 12 months’ worth of rent, so we will have to debit rent expense $12,000 and credit pre-paid rent expense to show that it’s been used up $12,000. We post that to the ledger and the new balance of pre-paid rent expense of the year X2 is now a debit of $4,000 which we then will use up in X3, debit rent expense $4,000 and credit pre-paid rent expense using that up $4,000 resulting in an ending pre-paid rent expense balance at the end of X3 of 0.
Slide 6
Back to the big picture, in X1 we recognize $2,000 of rent expense, in X2 $12,000 of rent expense and in X3 $4,000 of rent expense. Do our recognized expenses comply with the matching principle? Yes, they do.
Slides 7-9 (2m:14s)
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Slide 7
Example, on December 14th X1 House Co. paid $200 to Roofer Co. to REPAIR his old roof in February X2. On February X2, Roofer Co. repaired the roof by patching it. Record all required entries AND adjusting entries for House Co. from 20X1-20X2 as per the matching principle.
Per the matching principle when should House Co. recognize the repair expense?
On 12/14/X1 the payment was made. Cash was paid but no expenses should be recognized because the benefit has not been received yet. On February 8th X2, $200 of expenses should be recognized because that was when the repair was made and the benefit was received. Here’s a different question just to get you thinking and prepared for a later topic. What if House Co. paid $30,000 for a new 30 year roof? In this case the benefit will be received over a 30 year period and therefore that $30,000 payment would have to be spread over 30 years and expensed accordingly. We would call that depreciation expense and it would be $1,000 per year.
Slide 8
Let’s look at the journal entries. On December 14th, X1 the cash payment is made so we credit cash $200. We have not yet received the benefit so we need to debit an asset called pre-paid maintenance expense of $200. We post that as a debit to the pre-paid maintenance expense account to show we have an asset of $200 at the end of the year. No adjustments are needed yet because we haven’t received the benefit. In the following year when the service is actually provided on February 8th we will debit the maintenance expense of $200 and we are not paying cash now so what we will have to do is credit this asset [prepaid maintenance expense] showing it’s been used up. When we post that $200 credit to the pre-paid maintenance expense ledger account, we will end 20X2 with no remaining asset, which is what should’ve happened.
Slide 9
Let’s look at the big picture and see what happened on the income statement. In X1, cash was paid but no expenses were recognized, that’s what should’ve happened. In X2, $200 of maintenance expense was recognized. Did we handle that properly according to the matching principle? Yes we did.
Slides 10-11 (0m:46s)
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Slide 10
Here are some expense recognition key points to keep in mind.
- Only recognize the expenses in the accounting period in which the benefit is received, which should match the related revenue.
- If you acquire something that will provide future value, it will be an asset (often a prepaid- but not always) until the benefit is received and the asset is expensed.
- At year end, review all asset account balances to determine if they still have value, if not, record an adjusting entry to expense them.
- At year end, review your expense account balances to ensure no future value exists, if future value exists they may need adjusting.
Slide 11
Hopefully this has helped you understand the concept of deferred expenses where cash is paid before the expense is recognized. I wish you all the best on the quiz. ALOHA.