Recognition: formally

recording an item in

the financial statements

of an entity

Recognition and Measurement

I know I

need to

record

this...

Measurement:

quantification of the

economic effects of

the item on the entity

...but at

current value

or historical

cost?

Cash vs. Accrual Basis

Cash basis: revenues and expenses are

recorded only when cash is received or paid

Accrual basis: revenues are recognized when

earned; expenses are recognized when incurred

Cash basis

statement

Accrual basis

statement

Statement of

Cash Flows

Cash flows from

operating activities:

$(4,000)

Income

Statement

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 and

earnedusually at point of sale

Expense Recognition

Income Statement

PP&E

Intangibles

as used

Balance Sheet

when sold

over period they

provide benefits

ASSETS: EXPENSES:

Cost of goods sold

Supplies expense

Insurance expense

Rent expense

Depreciation expense

Amortization expense

Other expenses

(as incurred)

Inventory

Supplies

Prepaid assets

Matching Principle

Directly

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

Match expenses with associated revenues

Indirectly over

period they

provide benefits

Simultaneously

upon their

acquisition

Types of Adjusting Entries

RECOGNIZE

REVENUE OR

EXPENSES

BEFORE OR

AFTER CASH IS

EXCHANGED

Deferred

expense

Accrued

liability

Accrued

asset

Deferred

revenue

Deferred ExpenseCash 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 rent on office space for one year on September 1

Initial journal entry:

9/1 Prepaid Rent 2,400

Cash 2,400

Monthly adjusting journal entry:

9/30 Rent Expense 200

Prepaid Rent 200

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

Deferred Expense Example #1

Deferred Expense Example #2

Initial journal entry:

1/1 Store fixtures 5,000

Cash 5,000

Monthly adjusting journal entry:

1/31 Depreciation Expense 75 Accumulated Depreciation 75

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

Purchase new store fixtures on January 1 for $5,000.

Estimated useful life is 5 years (60 months); estimated

salvage value is $500

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 on

September 1

Initial journal entry:

9/1 Cash 2,400

Insurance Collected in Advance 2,400

Monthly adjusting journal entry:

9/30 Insurance Collected in Advance 200

Rent Revenue 200

($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 #1

At end of month, between pay periods:

Wages Expense 40,000

Wages Payable 40,000

Next payday:

Wages Payable 40,000

Wages Expense 240,000

Cash 280,000

Pay biweekly wages of $280,000

Accrued Liability Example #2

Initial journal entry:

3/1 Cash 20,000Note Payable 20,000

Monthly adjusting journal entry:

3/31 Interest Expense 150

Interest Payable 150

($20,000 principal 9% 3/12 = $450 for 3months or $450/3 = $150 per month)

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

loan is taken out with a bank

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

First day of the month:

Rent Receivable 2,500

Rent Revenue 2,500

Upon receipt of cash:

Cash 2,500

Rent Receivable 2,500

Rent payment of $2,500 due within first 10

days of month

Steps in the Accounting Cycle

1. Collect and

analyze info2. Journalize

transactions

3. Post

transactions to

general ledger

4. Prepare

work sheet

5. Prepare

financial

statements

6. Record and

post adjusting

entries

7. Close the

accounts

RevenuesNormal

balance

Nominal Accounts

Expenses

Normal

balance

DividendsNormal

balance

$ XX $ XX

$ XX

Zero out

nominal accounts

to start accumulation

of next periods

results

Close to

Income

Summary

$ XX

Close to

Income

Summary

$ XX

Close to

Retained

Earnings

$ XX

Closing Entries

(Net loss) or net income

closed to Retained Earnings

Income Summary$XX

from revenue

accounts

$XX

from expense

accounts

Accounting Tools:

Work Sheets

Unadjusted Trial Balance ColumnsBegin by filling in the trial balance accounts

and amounts

The Adjusting Entries Columns

Make adjustments;

formal journal entries

are prepared later

Adjusted Trial Balance Columns

The Income Statement Columns

Extend revenue and

expense account balances

to the income statement

The Balance Sheet Columns

Extend asset, liability,

and equity accounts to

the balance sheet