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Chapter 4

Income Measurement

and

Accrual Accounting

Financial Accounting, Alternate 4e by Porter and Norton

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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

effects of the item on the entity

...but at current value or historical

cost?

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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

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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?

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Revenue Recognition Principle

Exceptions: Long-Term Contracts - over life of project Franchises - upon substantial performance Commodities - when readily convertible Installment Sales - when cash is collected Rent and Interest - continuously when earned

Revenue is recognized when realized and earned - usually at point of sale.

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Expense Recognition

Income Statement

Inventory

SuppliesPrepaid assets

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 expense

Other expenses (as incurred)

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Matching Principle

Directly

Indirectlyover period theyprovide benefits

Simultaneouslyupon theiracquisition

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

Match Expenses with Associated Revenues

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Types of Adjusting Entries

ALL RECOGNIZE REVENUE OR

EXPENSE BEFORE OR

AFTER CASH IS EXCHANGED

Deferred expense

Accrued liability

Accrued asset

Deferredrevenue

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Deferred Expense - Cash paid before expense is incurred

Examples:» Prepaid rent

& insurance» Office supplies» Plant & equipment

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

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Deferred Expense Example #1 – Prepay rent on office space for one year on Sept. 1

Initial transaction:Assets = Liab. + O/E + Rev. – Exp.Prepaid Rent 2,400Cash (2,400)

Monthly adjustment:Assets = Liab. + O/E + Rev. – Exp.Prepaid Rent (200) Rent Exp. (200)

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Deferred Expense Example #2 - Purchase delivery truck on January 1 for $21,000. Estimated useful life is 5 years (60 months); estimated salvage value is $3,000.

Initial transaction:Assets = Liab. + O/E + Rev. – Exp.Delivery Truck 21,000Cash (21,000)

Monthly adjustment:Assets = Liab. + O/E + Rev. – Exp.Acc. Depr. (300) Depr. Exp. (300)

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Deferred Revenue - Cash received before revenue is earned

Examples:» Rent 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.

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Initial transaction:Assets = Liab. + O/E + Rev. – Exp.Cash 2,400 Rent Collected

in Advance 2,400

Monthly adjustment:Assets = Liab. + O/E + Rev. – Exp.

Rent Collected Rent Rev. 200 in Advance (200)

Deferred Revenue Example #1 - Receive $2,400 for twelve months rent in advance

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Initial transaction:Assets = Liab. + O/E + Rev. – Exp.Cash 6,000 Subs. Collected

in Advance 6,000

Monthly adjustment:Assets = Liab. + O/E + Rev. – Exp.

Subs. Collected Subs. Rev. 500 in Advance (500)

Deferred Revenue Example #2 -Sell 500 1-yr. subscriptions at $12 each

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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

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At end of month, between pay periods:Assets = Liab. + O/E + Rev. – Exp.

Wages Pay. 4,000 Wages Exp. (4,000)

Next payday:Assets = Liab. + O/E + Rev. – Exp. Cash (28,000) Wages Pay. (4,000) Wages Exp.

(24,000)

Accrued Liability Example #1 - Pay biweekly wages of $28,000

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Initial transaction:Assets = Liab. + O/E + Rev. – Exp.Cash 20,000 Notes Pay. 20,000

Monthly adjustment:Assets = Liab. + O/E + Rev. – Exp.

Interest Pay. 300 Interest Exp. (300)

Accrued Liability Example #2 - Borrow $20,000 for three months. Principal plus 9% interest due at end of loan period.

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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

Revenue

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First day of the month:Assets = Liab. + O/E + Rev. – Exp.Rent Rec. 2,500 Rent Rev. 2,500

Upon receipt of cash:Assets = Liab. + O/E + Rev. – Exp. Cash 2,500Rent Rec. (2,500)

Accrued Asset Example – Rent payment due within first 10 days of month

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Ethical Considerations

The accountant’s primary responsibility is to accurately portray the affairs of the company

in the financial statements

When to recognize expenses?

When to recognize revenue?

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Steps in the Accounting Cycle

1. Collect and analyze info

2. Journalizetransactions

3. Post J/Es togeneral ledger

4. Preparework sheet

5. Preparefinancial

statements

6. Record &post AJEs

7. Close theaccounts

Continuously

Periodically

End of the period

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Closing Entries

net income or (net loss)closed to

Retained Earnings

Revenue accounts $ xxExpense accounts (xx)

Return all balances in temporary accounts to zero for the next period

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End of Chapter 4