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Accounting for Accruals and Deferrals at the End of the Period

End of Year means accounting adjustments: measuring performance using accruals and deferrals (Part 2)
Once we have analyzed all the transactions, the nine plus three at the end of the year, we know that we have to deal with accrued revenues and accrued expenses deferred revenues and deferred expenses arising at the end of the year. We start analyzing which cost and revenues shall contribute to the estimation of the performance for the year. Let’s start with end of period information in relation to deferred expenses. Just a quick recap here might be helpful. Deferred expenses involve any asset that has been purchased during the year or in the previous years that have been used throughout the year.
So we ask the following question: Are there any assets that have been used during the period that should be expensed? Expensing and as it means that some of the value of that asset is gone and it’s not any longer available to the company in the future. For instance, the asset has lost value or the asset has contributed to the operations of the company. Once we’re done with the 9 plus 3 transactions that involved Food on the go during the first year of its operations.
We have now hit the point where we want to estimate the performance of the year and we know the accounting requires dealing with accruals and deferred revenues and expenses but that is with deferred expenses now deferred expenses. We tried to answer and address the following issue. Are there any assets that have been used during the period that should be expensed now? Remember food on the go bought scooters and a license and later on it made an investment in properties. Now we don’t know whether these assets have actually contributed to the generation of revenue throughout the year.
However, if the asset has lost value or if the asset has contributed to the operations of the company then we should book an expense. We can help ourselves using these timeline to understand the discrepancy between what happens at the time of the purchase and then the accrual or accounting process that helps us allocating the expenses. I show a time zero what we observe is that there is a purchase of scooters and there is a cash outflow or a bank disbursement. This is irrelevant because the company could also buy a debit. It is different when we look at the actual contribution and expense related to the use or the loss in value of these long lived assets.
And we had this valuable piece of information to start with that this scooter had the useful life of two years and in fact we know that from year 1 the scooters are usable. And then from one year to the next year, they usable again. If you take the estimated useful life at the end of the year 1 we try to assess what is the amount that has been used up and what is the residual value that has to be yet used.
Transaction number two: food on the go bought five electric scooters for 8,000 and the estimated useful life was three years so that means that those scooters have not been used up for the entire value throughout the year. And there is some sort of leftover how do we deal with this transaction from an accounting perspective. There are two different approaches that we that we can use and it would signal which one is our favorite. First we recognize in both cases that there is an amortization. Amortizing - if you remember - is the process through which we allocate the loss in value of long lived asset over the entire useful life. Here we have two options.
First, we reduce or deduct the value that is subject to amortization to the main account. We established and then keep using scooter account as an asset. We can directly deduct the value that is amortized to these items or we can rely on an accounting adjustment account that is quite common in relation to assets. In this case we signal separately in the financial statement or these the value of amortization over time while keeping the initial value of the asset as per original and then allows us to distinguish the initial value and the accumulated depreciation or amortization rather than having the net value. In both cases the effect on income and balance sheet is the same but the signaling quality is different.
However going back to the journal entry what we have
here we have an amortization account: it is an expense an increase in expense means a reduction in value of an asset means crediting for 4000. If you look at the alternative option we see that there is an amortization which is an expense four thousand with debit that corresponds to an increase in this account that is called adjustment account in relation to equipment (scooters). That means we have to deduct some of the original value of a thousand by half of it. We have the two alternative options that are signaled at the top or at the bottom that generate different types of account.
For instance, if you look at the upper option we have amortization of scooters that is going to be debited because it’s an expense account. On the other hand, we have equipment of scooters which is the original account we used to the set up at the inception. When we record the transaction we could still resort to the second option whereby we debit the amortization account and we credit an adjustment account. And as we can tell, we will always opt for the second option if you want to see clearly what happens.
Here you’ve got the figures: we debit the amortization account. We created the equipment scooter account or we debit the amortization account and we credit an adjustment account that will be used to deduct the initial value of the scooters to reflect the new value. If you remember the scooter was not the only long lived asset that food on the go bought during the year. Food on the Go also both a license to use a platform to handle the deliveries. The initial cost was twelve thousand but there was a contract for three years.
Regardless of the form of payment - whether it’s the bank or cash or through payables - what we are interested in here is estimating the expense or the cost connected to the usage of these license. And here again we have two ways in which we can account for these adjustment. Again we are dealing with deferred expenses the license will be amortized and the amortization will be proportional over time. So we take one third the amortization account features in option 1 or in option 2 and it features the same amount four thousand an expense account to be increased has to be debited and again here we have the same option that we discussed in relation to scooters.
We can either reduce the value of license directly so that by crediting of 4000
the value at the end of the year will be eight thousand: that is the true net that or we can still use an amortization account still for 4000; then we create this adjustment account. These adjustments account are very useful because they allow us to signal in the balance sheet that the original value of the license is going down as a result of the amortization. If we look at the accounts we can already foresee what’s going to happen. In both Option 1 and Option 2 we rely on amortization account licenses what has the difference here.
If we either credit the license account or we establish a new account which is called accounting adjustment and we know that our favorite option will always be the same. Let’s have a look at adjustment number three. Adjustment number three is different because it entails a change to deferred revenues.
If you remember transaction 4: on March the 30th a large company both at a discount 7200 meals will be delivered to its own employees for the next segment and paid upfront Food on the go. Twenty one thousand six hundred to have this service at their own disposal. However if we consider that we are going from March the 30th of year 1 until March the 30th of year 2 We know that some part of these revenues are unearned so we have to defer. How do we defer these revenues from an accounting perspective? Let’s start with the journal entry first and see how we handle it and then we’ll move to the account. First here we call these adjustments on Sales.
This is a revenue account but it’s a deduction in the revenue account because we want to discount or reduce the total amount of revenues if you remember a revenue account is credited with revenues increase and it would be debited with revenues decrease at the same time we book a revenue liability. Now this may sound as an oxymoron as a paradox but this is useful to signal that the company owes something to one of its customers and the value of the an earned services or product is seven thousand two hundred. This is the same as we can observe when we look at the accounts. So we have the two named after the unearned sales and the revenues liabilities.
And as you can see they bought adjustment. Number four refers again to deferred expenses. If you remember transaction nine food on the go on August 28 pays 1500 for the rental of its office space for six months. For the sake of simplicity we can easily estimate that not all the six months had been used up by the end of the year but given that there are two months that are still available to food on the go. So let’s say that out of the six month period one two three four months are gone. What has January and February are unused. How do we account for this?
This is a deferred expense we account for this in the following way in the journal entry. We book a prepaid rent which is an asset meaning that the company has still two months available and the value is five hundred which is one third of the six months paid and we basically rectified the rent the expenses because not all the 1500 that we booked we transaction nine are actually part of the income of the. This is reflected also in the T accounts where we use a prepaid rent account and rental expenses account which was initially debited for 1500 that is now rectified through a deduction of 500.

In this video we tackle the fundamental accounting problem of deferrals and accruals identified at the end of the period. We will continue building on the Food-on-the-Go case in order to analyse which revenues and expenses should be counted towards the estimation of the periodic income. Please be aware that the video in the previous step is a fundamental pre-requisite to fully appreciate the concepts introduced here.

In the following video, we will move towards the estimation of income and balance sheet at the end of the year.

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