2. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 1 Chapter 5 Keeping Score: Bases of Economic Measurement

3. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 2 Learning Objective 1 Explain the difference between reality and the measurement of reality.

4. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 3 Reality versus the Measurement of Reality As events occur, their effects are recorded in an attempt to measure the reality of the business. No matter how accurately the measurement of reality reflects reality, it is not reality.

5. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 4 The Problems of Periodic Measurement Most differences between reality and its measure occur when earnings activities are measured for a specific period of time. It is not always obvious which revenues and which expenses should be included in determining the earnings of that period.

6. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 5 The Problems of Periodic Measurement A company’s operations are artificially broken into time periods in order to determine when to report revenues and expenses. Year 2 Year 1

7. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 6 Accounting Principles Principles Principles 1. Historical cost 2. Revenue recognition 3. Expense recognition 4. Full disclosure

8. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 7 Recognition Recognition in accounting is the process of… recording in the books and… reporting on the financial statements.

9. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 8 Bases of Economic Measurement There are two basic approaches to recording economic activity. Cash basis Accrual basis

10. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 9 Bases of Economic Measurement Example Max Corkel started a company on January 2, 2003, by incorporating and purchasing 2,000 shares of no par common stock for $200,000. Corkel, Inc., borrowed $100,000 on January 2 by signing a one-year, 12% note payable. Interest charges must be paid each month. On January 2, the company purchased a vehicle for $14,000 cash. Its estimated salvage value is $2,000, and its estimated useful life is 4 years.

11. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 10 Bases of Economic Measurement Example The company paid cash for $75,000 of merchandise inventory on January 8. On January 15, the company sold $42,000 of its inventory for $78,000 cash. On January 22, the company sold $15,000 of its inventory for $32,000 on account. The terms of the sale were 30 days.

12. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 11 Bases of Economic Measurement Example Cash payments for operating expenses in January totaled $22,500. At the end of the month, the company owed $2,000 to employees for work performed in January. They will be paid on February 3. The company owed $700 at the end of the month for a utility bill that was received on January 26 and will be paid on February 15.

13. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 12 Learning Objective 2 Apply the criteria for revenue and expense recognition under the cash basis of accounting to determine periodic net income.

14. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 13 Cash Bases of Economic Measurement Economic activities are recognized only when cash is paid or cash is received. Revenues are recognized when cash is received. Expenses are recognized when cash is paid.

15. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 14 Cash Basis Income Statement Corkel Inc. Income Statement For the Month Ended January 31, 2003 Sales revenue$78,000 Cost of goods sold 75,000 Gross margin$ 3,000 Expenses: Cost of vehicle$14,000 Cost of vehicle$14,000 Cash operating expenses 22,500 Cash operating expenses 22,500 Total operating expenses 36,500 Net loss($33,500)

16. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 15 Cash Basis Statement of Stockholders’ Equity Corkel Inc. Statement of Owners’ Equity For the Month Ended January 31, 2003 Common Stock Retained EarningsTotal Balances 1/1/2003$ 0$ 0$ 0 Sale of common stock 200,000 200,000 Net loss (33,500) (33,500) Balances 1/31/2003$200,000($33,500)$166,500

17. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 16 Cash Basis Balance Sheet Assets:Liabilities: Cash$266,500 Notes payable$100,000 Cash$266,500 Notes payable$100,000 Stockholders’ equity: Common stock 200,000 Common stock 200,000 Retained earnings – 33,500 Retained earnings – 33,500 Total stockholders’ equity$166,500 Total liabilities and stockholders’ equity stockholders’ equity Total assets$266,500$266,500 Corkel Inc. Balance Sheet January 31, 2003

18. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 17 Strengths and Weaknesses of Cash Basis Accounting Strengths 1. Keeps focus on cash flows. 2. It is relatively objective. Weaknesses 1. It makes no attempt to match expenses and revenues. expenses and revenues. 2. Statements are difficult to use.

19. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 18 Learning Objective 3 Apply the criteria for revenue and expense recognition under the accrual basis of accounting to determine periodic net income.

20. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 19 Accrual Basis of Economic Measurement Accrue means to come into being as a legally enforceable claim. Accrual accounting focuses on the earnings process rather than the cash flows resulting from that process.

21. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 20 Accrual Basis Revenue Recognition Revenues and gains of an enterprise during a period are generally measured by the exchange values of assets or liabilities involved. Recognition involves: being realized or realizable being earned

22. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 21 Accrual Basis Revenue Recognition Cash is received at the time the revenue is earned. Relationships between cash and revenue: Cash is received after the revenue has been earned. Cash is received before the revenue has been earned.

23. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 22 Accrual Basis Expense Recognition Expenses are assets used up in delivering or producing goods, or rendering services. Expense recognition is completely unrelated to the movement of cash.

24. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 23 Learning Objective 4 Explain the concept of matching and describe how it relates to depreciation.

25. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 24 The Concept of Matching Accrual accounting uses accrual, deferral, and allocation procedures whose goal is to relate revenues, expenses, gains, and losses to periods to reflect an entity’s performance during a period. When to recognize revenues Which expenses helped to generate that revenue

26. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 25 Depreciation Depreciation is a systematic and rational allocation of the cost of a long-lived item from asset to expense. This allocation requires two estimates: Useful life Residual value

27. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 26 Depreciation What is the depreciation per year for Corkel’s vehicle? per month? (Cost – Residual value) ÷ Useful life ($14,000 – $2,000) ÷ 4 = $3,000 $3,000 ÷ 12 = $250

28. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 27 Learning Objective 5 Describe the difference between accruals and deferrals and identify examples of each.

29. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 28 Accruals and Deferrals Accrual accounting attempts to recognize revenues in the income statement period they are earned, and attempts to match the expenses that generated that revenue to the same income statement period. The two basic types of adjustments that are necessary are accruals and deferrals.

30. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 29 Accruals Accrual adjustments recognize revenue or expense before the associated cash is received or paid. AccruedrevenuesAccruedexpenses

31. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 30 Accrued Revenues Example Warner Management Consulting Services, Inc. sends bills on the 2 nd of each month for work done during the previous month. During the month of December 2003, the company rendered services to clients totaling $50,000. When is this revenue recognized?

32. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 31 Accrued Expenses Example Pellum Company pays its employees $20,000 every two weeks for work performed in the previous two weeks. If part of the two-week pay period is in 2004 and part is in 2005, what is the adjustment at the end of 2004?

33. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 32 Accrued Expenses Example December 2004 25 26 27 28 29 30 31 $10,000 expense 1 2 3 4 5 6 7 1 2 3 4 5 6 7 January 2005

34. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 33 Deferrals Deferrals are postponements of the recognition of revenue or expense even though the cash has been received or paid. DeferredrevenuesDeferredexpenses

35. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 34 Deferred Revenues Example On June 1, Larry’s Lawn Service received $450 for providing lawn care to a family for June, July, and August. How much revenue should be recognized on June 30? June 1 Liability $450 June 30 Revenue $150 June 30 Liability $300

36. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 35 Deferred Expenses Example On January 2, 2004, Crockett Cookie Company purchased a three-year insurance policy for $2,175. How much is the insurance expense for 2004?

37. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 36 Accruals Accruals and Deferrals Deferrals Characteristics: Characteristics: 1. A revenue or an expense item will always be affected. will always be affected. 2. An asset or a liability item will always be affected. will always be affected. 3. Cash is never affected.

38. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 37 Learning Objective 6 Contrast the cash basis and accrual basis of economic measurement, describing the relative strengths and weaknesses of each.

39. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 38 Accrual Basis Income Statement Corkel Inc. Income Statement For the Month Ended January 31, 2003 Sales revenue$110,000 Cost of goods sold – 57,000 Gross margin$ 53,000 Expenses: Cash operating expenses$22,500 Cash operating expenses$22,500 Wage expense 2,000 Wage expense 2,000 Utilities expense 700 Utilities expense 700 Depreciation expense 250 Depreciation expense 250 Total operating expenses 25,450 Operating income$ 27,550 Other expenses, interest – 1,000 Net income$ 26,550

40. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 39 Accrual Basis Statement of Stockholder’s Equity Corkel Inc. Statement of Stockholders’ Equity For the Month Ended January 31, 2003 Common Stock Retained EarningsTotal Balance 1/1/2003$ 0$ 0$ 0 Sale of common stock 200,000 200,000 Net income 26,550 26,550 Balance 1/31/2003$200,000$26,550$226,550

41. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 40 Accrual Basis Balance Sheet Assets:Liabilities: Cash$266,500Accounts payable$ 700 Accounts rec. 32,000Wages payable 2,000 Inventory 18,000Interest payable 1,000 Vehicle$14,000Notes payable 100,000 AccumulatedTotal liabilities$103,700 depreciation – 250Stockholders’ equity: depreciation – 250Stockholders’ equity: Vehicle, net 13,750 Common stock 200,000 Retained earnings 26,550 Total stockholders’ equity 226,550 Total liabilities and Total assets$330,250 stockholders’ equity$330,250 Corkel Inc. Balance Sheet January 31, 2003

42. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 41 Strengths and Weaknesses of Accrual Basis Accounting Strengths Strengths 1. It establishes a relationship between revenues and the expenses incurred to generate the revenue. the expenses incurred to generate the revenue. 2. It is helpful to economic decision makers. Weaknesses Weaknesses 1. It takes the user’s eye off cash. 2. Does not provide information about cash flows.

43. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones5 - 42 End of Chapter 5