Study: Accrued Expenses: Cash is Paid AFTER Expense is Recognized
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Slides 1-4 (1m:24s)
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Slide 1
Welcome to Introduction to Accounting Preparing for a User’s Perspective. Accrued Expenses: Cash is paid AFTER expense is recognized.
Slide 2
In the prior video on deferred expenses I introduced this slide but the basic idea is that I’m just showing that we have revenues and that in the same accounting period we need to match and record the related expenses.
Slide 3
In this video we will talk about the third situation of the matching principle and that’s when cash is paid AFTER the benefit is received and the expense is recognized. This will result in an increase in accrued expenses and an increase in a liability until the expense is paid off.
Slide 4
Deferred Expenses: To “defer” means to put off until later; therefore, “deferred” expenses are expenses whose recognition is put off into the future even though payment has been made now.
Accrued Expenses: To “accrue” means to grow or to accumulate over time. In accrual accounting, if the matching principle criteria are met in the current period, expenses will need to be “accrued” into the current accounting period even if cash will not be paid out until a later accounting period. When an expense is accrued and paid later a liability exists during this period waiting for the payment.
When cash is paid now and the expense is incurred later this will result in an asset that then gets used up when the expense is actually recognized.
Slides 5-7 (3m:28s)
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Slide 5
Example: On May 1st X1, Borrower borrowed $10,000 from Lender Co. for 12 months at 12% simple interest. All interest and the principal are to be paid on April 30th X2. Per accrual accounting, record all required entries for Borrower Co. on May 1st X1, December 31st X1, and April 30th X2. Per the matching principle when should the interest expense be recognized?
The loan was taken out on May 1st and that money was effectively rented for 12 months to be repaid on April 30th of X2. The interest rate will result in a $1,200 interest charge against the borrower.
If you take the principle of $10,000 multiplied by 12% per year, and were just computing it for a full 12 month period, it would be $1,200 for a full 12 month period; however, that 12 month period straddles two accounting periods X1 and X2.
So how much interest expense should be recorded in X1 and how much should be recorded in X2?
If it’s $1,200 per year for 12 months, that effectively means that it’s $100 per month; therefore, since there are 8 months in X1 that will be $800. You could also compute that $800 by taking the full principle [$10,000] times 12% times 8/12 of a year. In the following year it’s $400 which is 4/12 of a year. In total it winds up being $1,200 as expected with $800 being recognized in X1 and $400 being recognized in X2.
Slide 6
The journal entries need to reflect what we just learned. On May 1st the loan was taken out. We debit cash so we have more cash $10,000 and we credit note payable $10,000 showing we owe more to the bank. Then at the end of the year we have to look at this and say wait we borrowed this money now for 8 months and we haven’t recorded any interest expense yet.
How much interest expense should we accrue into this accounting period to comply with the matching principle?
And the answer is interest expense would be debited $800 to increase the expense and since we haven’t paid for it yet we would credit a payable $800 showing we owe that money in the future. We post that credit to the interest payable account $800, to show that at the end of 12/31/X1 we owe $800 of interest, which we know we will have to pay off on April 30th of next year.
On April 30th of the next year we have to accrue another $400 of interest expense for the 4 months that occurred in X2 and we have to pay off the payable. Here we owed it as a credit, and now we are going to debit it to show that we paid it off. We are also going to eliminate the note payable of $10,000 by debiting that. In total we must pay cash, credit $11,200 to fully satisfy the lender. By posting the debit to interest payable, we will wind up with no further interest payable at the end of X2.
Slide 7
Stepping back to the big picture we recorded interest expense of $800 in X1 and interest expense of $400 in X2. Do our recognized expenses comply with the matching principle? Based on what we saw in the prior slides we show that $800 should’ve been [recognized] in X1 and $400 should’ve been [recognized] in X2, for a total of $1,200 for the full year period. Yes, we did comply.
Slides 8-10 (2m:45s)
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Slide 8
Example: On December 1st, X5, New Co. signed a contract to receive $9,000 of consulting services from Consultant A over the three month period ending 2/28/X6. Assuming the services were provided evenly and New Co. paid for them on 2/28/X6, record all of New Co.’s required entries AND adjusting entries for 20X5 and 20X6 to comply with the matching principle. Per the matching principle, WHEN should New Co. recognize the consulting expense?
And the answer is, when they receive the benefit. On December 1st, no benefit had been received yet. They had signed a contract but no benefit had been received yet. However, by the end of the year they will have used up 1 month worth of consulting services. So if you take the full $9,000 divided by 3 months, that’s $3,000 of consulting expense per month, by the end of X5 you will have incurred $3,000 of consulting expense even though no cash had been paid. In the following year, two more months would have been used up so $6,000 of consulting expense would’ve been recognized in X6 and a $9,000 cash payment would have had to be made, $6,000 of that relates to the current year consulting expense and $3,000 of that is related to the prior year consulting expense.
Slide 9
The journal entries. On December 1st no entry needs to be made because no services had been received. However, jumping ahead 1 month to December 31st, X5, $3,000 of consulting expense needs to be accrued, debit consulting expense of $3,000, and since we haven’t paid for it, yet we would have to credit a liability. We call that liability an accrued expense of $3,000. We then post that credit to the accrued expenses ledger account to show that at the end of the year we owe $3,000 to the consulting firm. In the following year on February 28th we will actually receive two more months of the consulting services and pay for them. Debit consulting expense of $6,000 for the current year consulting expense and pay $9,000 [of cash]. Now as you can see the debits do not equal the credits we need $3,000 more debit and that $3,000 more debit is the paying off of the prior year [X5] liability of $3,000. By posting that to the ledger account we wind up with no further accrued expenses owing at the end of X6.
Slide 10
Stepping back looking at the big picture again, we recorded $3,000 of the consulting expense in X5 even though no cash was paid. Then we recorded another amount of $6,000 consulting expense and fully paid off all accrued amounts. Did New Co. properly comply with the matching principle and accrue the expenses into the correct periods? Yes it did.
Slides 11-12 (0m:47s)
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Slide 11
Accrued expenses: expense recognition key points.
- Only recognize expenses in the accounting period in which the benefit is received, which should match the related revenue.
- If you receive and use up a service that you haven’t yet paid for, you will need to accrue and recognize the expense now and pay the liability off later. That liability is often called an accrued expense.
- At year end, review all accrued expense account balances, to determine if they are properly stated, and adjust accordingly.
- At year end, review your expense accounts to ensure you have accrued all appropriate expenses whether cash has been paid or not.
Slide 12
Hopefully, this has helped you to better understand accrued expenses where cash is paid AFTER the expense is recognized. I wish you all the best on the quiz. ALOHA