Introducing the Accounting Identity

Welcome in this video. We will deal with the time differences between the revenue recognition and the cash collection. And also we will deal with the time differences between the expense recognition and the cash collection. And then we will see what accruals and deferrals are remember. Transaction eleven accordingly sells for fifty thousand were recognized as revenue even if only half of the payment was immediately paid in cash. Twenty five thousand the other half was recorded as receivable for twenty five thousand and receivable is an accrual.

It is a recorded transaction even if the payment for that particular product or service has not been received and has not been collected yet here in the picture you see that right now in the current period we book a receivable and revenue while the cash inflow will be collected only in the next period to deal with the problem that some customers may not pay the full amount of cash that they owe to the firm for products or services received. The firm creates an account called allowance for bad receivables. For example work for less has receivables for twenty five thousand. And it estimates that 5 percent of this twenty five thousand will not be collected.

That means that the firm believes that there is a possibility that 5 percent of the 25000 receivables will not be cashed in ever so the firm creates an allowance for bad receivables with a balance of 5 percent of twenty five thousand. That is one thousand and two hundred fifty. Now let’s think about another type of transaction one for less used electricity in its office. The utility bill will arrive only the next January during the next period for this current period the company records a utility expense but the cash payment will not occur now as the bill is due in the next period. This type of expense is called accrued expense. Another type of accrual in the figure.

Here you have the expense that happens now and it’s booked now while the cash flow will happen only in the next period. Remember how depreciation works. We split the cost of the plant over its estimated useful life and then allocate only one portion of the expense to the current period from the 60 thousand cost of the plant were divided by the number of years is expected useful life. We get the yearly plant expense of six thousand when work for less acquires a plant in transaction 5. It pays half of the cost in cash and half with a payable. However it does not record the entire cost of sixty thousand in this current period expenses in the first year.

It allocates only the depreciation expense. That is the portion of the cost of the plant that refers to this current period only EUR 1 now in year one we have the cash flow and the portion of expense. The depreciation expense for the current year. Some assets do not have a physical substance. They are not tangible. For example the patent that word for less acquired for 20000 is called an intangible asset. The process to allocate the cost of an intangible asset over its useful life is called amortization. And the technique is exactly the same as the one used for depreciation in the patent example. Expected useful life was five years now in year one.

We have a cash outflow for the entire amount and the expense that refers only to this current period the patent expense on December 15. Worthless receives an anticipated cash payment from a new client for a service to be provided the next year. During February as the service has not been delivered yet Werfel last cannot recognize the revenue even if it has received the cash. This payment corresponds to an unearned service revenue. This is called a deferral. The revenue recognition is postponed deferred. In this current period now we have the cash inflow and the unearned service revenue while the revenue will be recognized only the next period.

On December 30 first work for less pays for bonds or rent in advance for a new office space. The monthly rent is three thousand so the anticipated cash payment is twelve thousand. This corresponds to a prepaid expense the rent expense will be recognized only the next period. Even if the cash outflow happens now this is also a type of deferred in this case. In the current period now we have the cash outflow that corresponds to the prepaid expense.

While the expense will be only recognized later in the next period to summarize accruals and deferrals in the accrual case right now we have a revenue and expense recognition while later on in time we will have cash inflow or outflow that corresponds to the revenue and expense the deferrals are quite the opposite. First right now we have cash inflow or outflow while the revenue or related expense will only be recognized at a later point in time. Here is a table that summarizes each type of transaction into accruals and deferrals.

We can see depreciation as a type of deferral because with a depreciation first we have the cash outflow and then the depreciation expenses will be only recognized at different points in time. And now it’s your turn. Just thought the arrow.