1 Chapter 4 Income Measurement and Accrual Accounting Financial Accounting, Alternate 4e by Porter...

1

Chapter 4

Income Measurement

and

Accrual Accounting

Financial Accounting, Alternate 4e by Porter and Norton

2

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?

3

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

4

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?

5

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.

6

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)

7

Matching Principle

Directly

Indirectlyover period theyprovide benefits

Simultaneouslyupon theiracquisition

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

Match Expenses with Associated Revenues

8

Types of Adjusting Entries

ALL RECOGNIZE REVENUE OR

EXPENSE BEFORE OR

AFTER CASH IS EXCHANGED

Deferred expense

Accrued liability

Accrued asset

Deferredrevenue

9

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

10

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)

11

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)

12

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.

13

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

14

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

15

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

16

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

17

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.

18

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

19

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

20

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?

21

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

22

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

23

End of Chapter 4