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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 economic effects of the item on the entity
...but at current value or historical
cost?
LO1
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 and earned—usually at time of sale
LO3
Matching 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 Adjusting Entries
RECOGNIZE REVENUE OR
EXPENSES BEFORE OR AFTER
CASH IS EXCHANGED
Deferred expense
Accrued liability
Accrued asset
Deferredrevenue
LO5
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 rent on office space for one year on September 1Initial journal entry:9/1 Prepaid Insurance 2,400
Cash 2,400Monthly adjusting journal entry:9/30 Insurance Expense 200
Prepaid Insurance 200($2,400 annual × 1/12 = $200 per month for 12 months)
Deferred Expense Example
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 200Insurance 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
At end of month, between pay periods: Wages Expense 40,000
Wages Payable 40,000
Next payday:Wages Payable 40,000Wages Expense 240,000
Cash 280,000
Pay biweekly wages of $280,000
Accrued Liability Example #2
Initial journal entry:3/1 Cash 20,000
Notes Payable 20,000Monthly adjusting journal entry:3/31 Interest Expense 150
Interest Payable 150($20,000 principal × 9% × 3/12 = $450 for 3 months or
$450/3 = $150 per month)
On March 1, assume a 9%, 90-day, $20,000 loan is taken out with a bank
Accrued Liability Example #2(continued)
5/30 Interest Payable 300Interest Expense 150
Notes Payable 20,000Cash 20,450
To record payment of a 9%, 90-day, $20,000 loan with interest due 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
First day of the month:Rent Receivable 2,500
Rent Revenue 2,500Upon receipt of cash:
Cash 2,500 Rent Receivable 2,500
Rent payment of $2,500 due within first 10 days of month
Adjusting Entry 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
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 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 of the period to Retained Earnings
RevenuesNormalbalance
Nominal AccountsExpenses
Normalbalance
DividendsNormalbalance
$ XX $ XX
$ XX
Zero outnominal accounts
to start accumulation of next period’s
results
Close to Income
Summary
$ XX
Close to Income
Summary
$ XX
Close to RetainedEarnings
$ XXLO7
Closing Entries
(Net loss) or Net Incomeclosed to Retained Earnings
Income Summary$XX
from revenueaccounts
$XX from expense
accounts