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Chapter 3

Measuring Business Income

Financial & Managerial Acct

(Needles/Powers/Crosson)Slide show (Financial Accounting 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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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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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 J/E: Dr. Cr.Prepaid Rent 2,400

Cash 2,400

Monthly adjusting J/E:Rent Expense 200

Prepaid Rent 200($2,400 annual x 1/12 = $200 per mo. for 12 mos.)

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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 J/E: Dr. Cr.Delivery Truck 21,000

Cash 21,000

Monthly adjusting J/E:Depreciation Expense 300

Accumulated Depreciation 300 ($21,000 - $3,000) x 1/60 = $300 per mo. for 60

mos.)

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

Initial J/E: Dr. Cr.Cash 2,400

Rent Collected in Advance 2,400

Monthly adjusting J/E:Rent Collected in Advance 200

Rent Revenue 200( $2,400 annual x

1/12 = $200 per mo. for 12 mos.)

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

At end of month, between pay periods: Dr. Cr.

Wages Expense 4,000

Wages Payable 4,000

Next payday:Wages Payable 4,000Wages Expense 24,000

Cash 28,000

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

Initial J/E: Dr. Cr.Cash 20,000

Note Payable 20,000

Monthly adjusting J/E:Interest Expense 150

Interest Payable 150( $20,000 principal x 9% x 3/12 = $450

for 3 months or $450/3 = $150 per month)

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

First day of the month: Dr. Cr.Rent Receivable 2,500

Rent Revenue 2,500

Upon receipt of cash:Cash 2,500

Rent Receivable 2,500

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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

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Closing Entries

(net loss) or net incomeclosed to retained earnings

Income Summary$xx

from revenueaccounts

$xx from expense

accounts

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Appendix

Accounting Tools:

Work Sheets

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Unadjusted Trial Balance columns

Begin by filling in the trial balance accounts and amounts

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Adjusting Entry columns

Make adjustments. Formal journal entries are prepared later.

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Adjusted Trial Balance columnsAdd or

subtr

act

adju

stmen

ts fo

r

adju

sted ac

ct. b

alan

ces

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Income Statement columns

Extend revenue and expense account balances to the income statement

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Balance Sheet columns

Extend asset, liability and equity accounts to the balance sheet