0:20
First, let's imagine that on April 1st of year x3, the campus bookstore purchases
an insurance, a multi-risk insurance, to protect the business against thefts,
against fire, and many other risks you're going to have in a normal business.
The campus bookstore prepays 1,200 euros on April 1st.
And this amount will cover the company for one full year.
So at this moment, how would you account for this transaction?
We've seen this before, right, with the prepaid rent.
So these would be very similar.
First, we would credit cash because we are paying, there is a cash decrease.
Second, we would debit the prepaid insurance.
So we have an asset because it's something that we have purchased, we own it.
It's a result of a past transaction, and it has a future value.
It will give us a service for one full year.
Now, the next thing is, in year three, what's going to happen at the end
of year three, do we need to recognize anything else on December 31st?
Well, we need to recognize that 9 months have already passed since we purchased
that insurance, and therefore, the insurance has lost part of its value.
So we need to recognize the loss in value of the asset and
the corresponding expense.
So how would you account for these 900 euros?
So if we paid 1,200 euros in the beginning and that covers us for
12 months, for 9 months, we have already consumed 900 euros.
How would you recognize this expense of 900 euros?
Should we actually recognize anything?
Because you already prepaid for the full insurance.
1:49
Well, we actually do.
So 9 months have passed, we need to recognize that loss of value of the asset.
And still on the balance sheet,
we're going to find at the end of the year like 3 months left of this asset.
So we still have like prepaid insurance, 300 euros.
2:07
What we do is cash is not going to change of course, because we already prepaid for
that insurance.
What's going to happen is that the value of the asset goes down.
So we credit prepaid insurance for 900 euros, and on the other side,
we recognize an expense of 900 euros by debiting the profit and loss account.
So the shareholders of the company are now poorer by 900 euros because one of
the assets has lost this value.
As mentioned, at the end of the year,
the ending balance of the prepaid insurance is going to be 300.
It's going to cover us for 3 more months.
Now, let's consider a second example.
2:40
Let's assume that the campus bookstore receives another bank loan for
10,000 euros.
So with debit cash and with credit bank loan and because of this loan is 5%,
this interest is paid at the end of each year after getting the loan.
So the next payment is going to be on June 30th of year x4.
The total interest paid after one year is going to be 5% of 10,000, so 500 euros.
Now, we are still in the year x3.
So my question to you is, at the end of the year x3, so on December 31st of year
x3, do we need to recognize anything about this interest, about this loan?
Remember, we don't need to pay anything,
actually the interest paid is going to happen next year.
3:24
So what would you do on December 31st of your x3?
Well, because of accrual accounting,
we should recognize that we have been using the loan for 6 months.
Therefore we have to accrue the interest expense for 6 months, and
we have an obligation to pay that.
The payment is going to be next year, but
we already have to recognize the expense that has been accrued so far.
So to account for this transaction at the end of year x3,
we would debit the profit and loss account with interest expense.
So we are poorer now.
This is the cost of the service of getting this loan for 6 months.
And second, we are not paying but we have an obligation with the bank.
So there is a liability that goes up with credit interest payable.
Let's move to the last example.
4:10
Let's assume now that the corporate customer of the campus bookstore places
an order of 10,000 euros.
On that same date, March 31st, the company also makes a cash advance of 6,000 euros.
Christina doesn't have those books in stock, so
she has to order them from the suppliers.
On May 31st, Christina receives the books and delivers them to the customer.
The customer makes the rest of the payment of 4,000 euros 1 month later.
So the first question, what would we do with the order,
do we need to recognize anything here?
Well, it turns out that orders are not recorded.
The only thing that we record is any time that we get some cash or
that we are delivering some product.
But the promise in itself is just a promise that we're going to deliver
at some point.
Obviously something important is relevant information but
accounting doesn't reflect this information.
Still in certain industries, regulators require companies to
report this information, which is called order backlog.
Obviously, if you were a shareholder in this company,
maybe this is the kind of question you would ask.
So how many orders do you have in the pipeline?
Now what about the advance?
5:13
The advance from the customer has to be recognized because we have a cash inflow.
So we are going to debit cash.
Cash is going to increase.
I'm going to credit a new obligation that we have to deliver that product or
at least to return that money.
We're going to call these advances from customers.
So, debit cash 6,000, credit advances from customers 6,000.
This account of advances from customers is also called unearned revenues,
deferred revenues, or deposits from customers.
Next, we need to account for the delivery.
So, at the moment, we deliver is when we recognize the revenue.
So, we would credit the profit and loss account.
Now part of this revenue, we have already collected it, so
the only thing we are doing here is fulfilling the obligation we had.
So, we are going to decrease the advances from customers because now we
are delivering so we debit advances from customers.
6:03
The remaining part that we still have to pay is going to be debited
in accounts receivable.
So we debit 4,000 euros in accounts receivable.
Finally, we are going to recognize the remaining payments,
the remaining collection of cash, so on June 30th, we recognize a debit in cash.
We increase cash, we collect the cash and credit in accounts receivable.
Note that in this particular example,
we recognize revenue even though there is no cash involved.
Part of the cash was paid in advance, and
the rest of the cash is going to be collected in the future.
6:36
This is another example of accrual accounting at work.
We recognize economic events that sooner or later,
will affect cash whenever they take place, no matter whether the cash collection or
payment happens at that same moment.
I hope that the past three examples help you clarify the concept of
accrual accounting.
With this notion in mind, let's move on now to the analysis of the financial
statements of the campus bookstore for the past two years.
[MUSIC]
Marc BadiaAssistant Professor
