8/e

4

Income Measurement

and Accrual

Accounting

RecognitionThe process of formally recording or incorporating an item into the financial statements of an entity as an asset, a liability, a revenue, an expense, and the like. Sales

MeasurementHistorical Cost – simplest and most verifiableCurrent Value – the estimated value of the asset

Reliability vs. Relevance

Because of its objective nature, historical cost is the attribute used to measure many non-current assets.

Cash vs. Accrual Basis

Cash basis: revenues and expenses arerecorded only when cash is received or paid

Accrual basis: revenues are recognized whenearned; expenses are recognized when incurred

LO2

Cash basisstatement

Accrual basis statement

Statement ofCash Flows

Cash flows from operating activities:

$(4,000)

IncomeStatement

Net income: $ 7,000

What accounts for the difference?

Revenue Recognition Principle

Exceptions: Long-term contracts Franchises Commodities Installment sales Rent and interest

Revenue is recognized when realized or realizable and earned—usually at time of sale

LO3

Expense Recognition Principle

Directly

e.g. Inventory e.g. Buildings e.g. Utilities

Match expenses with associated revenues

Indirectly over period they

provide benefits

Simultaneouslyupon their acquisition

LO4

Expense RecognitionIncome Statement

PP&EIntangibles

as used

Balance Sheet

when sold

over period they provide benefits

ASSETS: EXPENSES:Cost of goods sold

Supplies expenseInsurance expenseRent expense

Depreciation expenseAmortization expenseOther expenses

(as incurred)

Inventory

SuppliesPrepaid assets

l

Types of Adjustments

RECOGNIZE REVENUE OR

EXPENSES BEFORE OR AFTER

CASH IS EXCHANGED

Deferred expense

Accrued liability

Accrued asset

Deferredrevenue

LO5

Adjustments SummaryExamples: Deferred Expense cash received before expense is incurred Deferred Revenue cash received before revenue is earned Accrued Liability expense incurred before cash is paid Accrued Asset revenue is earned before cash is received

Deferred Expense Cash paid before expense is incurred Examples:

• Prepaid rent • Prepaid insurance• Office supplies• Property and equipment

Costs are initially recorded as assets and allocated to expenses in future periods

Prepay $2,400 for insurance for one year on September 1

Deferred Expense Example

September 30 adjustment to recognize insurance expense:

Deferred Expense Example

$2,400 / 12 months = $200 /month

Deferred Expense Example

Purchase of Store fixtures:

Purchase new store fixtures on January 1 for $5,000; estimated useful life is 5 years 60 months); estimated salvage value is $500

Deferred Expense Example Monthly adjustment:

($5,000 – $500) × 1/60 = $75 per month for 60 months)

Deferred Revenue Cash received before revenue is earned Examples:

• Insurance collected in advance• Subscriptions collected in advance• Gift certificates

Receipts are initially recorded as liabilities (unearned or refundable receipts) and recorded as revenues in future periods when earned

Deferred Revenue Example Received $2,400 for an insurance policy in advance:

Deferred Revenue Example Monthly adjustment:

($2,400 annual × 1/12 = $200 per month for 12 months)

Accrued Liability Expense incurred before cash is paid Examples:

• Payroll• Taxes• Interest

Record expense (and corresponding liability) in period incurred; pay for it in a future period

No cash flow on recording, only when paid

Accrued Liability Example

Biweekly wages are $280,000

Accrued Liability Example At end of month, between pay periods:

Accrued Liability Example Next payday:

Accrued Liability Example

On March 1, assume a 9%, 90-day, $20,000 loan is taken

Accrued Liability Example

Monthly adjustment:

($20,000 principal × 9% × 1/12 = $150/month )

Accrued Liability ExamplePayment of principal and interest on May 30

Accrued Asset Revenue earned before cash is received Examples:

• Rent• Interest

Record revenue (and corresponding receivable) in period earned; receive payment in a future period

Accrued Asset Example Rent payment of $2,500 due within first 10 days of month

Accrued Asset Example Upon receipt of cash:

Adjustments SummaryExamples: Deferred Expense cash received before expense is incurred Deferred Revenue cash received before revenue is earned Accrued Liability expense incurred before cash is paid Accrued Asset revenue is earned before cash is received

Ethics and Accrual Accounting

Accountants must remember their primary responsibility is preparing financial statements is to portray the affairs of the company accurately to various outside users. Bankers, stockholders, and others rely on the accountant to serve their best interests.

Steps in the Accounting Cycle1. Collect and analyze info

2. Journalizetransactions

3. Post transactions togeneral ledger

4. Preparework sheet

5. Preparefinancial

statements

6. Record andpost adjusting

entries

7. Close theaccounts

LO6

The Use of a Worksheet Used at the end of the period to gather the information needed to prepare financial statements without actually recording and posting entries The worksheet is not a financial statement Useful device to organize the information needed to prepare the financial statements at the end of the period

The Closing Process

Purpose: To return the balance of revenue, expense, and dividend accounts to zero to begin the next period to transfer the net income (or loss) and

dividends of the period to Retained Earnings

Interim Statements Financial Statements prepared monthly, quarterly or at other intervals less than a year

Used for internal purposes