1 Chapter 4 Income Measurement and Accrual Accounting Financial Accounting 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 basis statement Accrual basis statement Statement of Cash Flows Cash flows from operating activities : $(4,000) Income Statement Net income $ 7,000 What accounts for the difference?

5 Revenue Recognition Principle Exceptions: l Long-Term Contracts - over life of project l Franchises - upon substantial performance l Commodities - when readily convertible l Installment Sales - when cash is collected l Rent and Interest - continuously when earned Revenue is recognized when realized and earned - usually at point of sale.

6 Expense Recognition Income Statement Inventory Supplies Prepaid assets PP&E Intangibles as used Balance Sheet when sold over period they provide benefits ASSETS:EXPENSES: Cost of goods sold Supplies expense Insurance expense Rent expense Depreciation expense Amortization expense Other expenses (as incurred)

7 Matching Principle Directly Indirectly over period they provide benefits Simultaneously upon their acquisition 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 Deferred revenue

9 Deferred Expense - Cash paid before expense is incurred l Examples: » Prepaid rent & insurance » Office supplies » Plant & equipment l 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 J/E: Dr. Cr. Prepaid Rent2,400 Cash2,400 Monthly adjusting J/E: Rent Expense 200 Prepaid Rent 200 ($2,400 annual x 1/12 = $200 per mo. for 12 mos.)

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 J/E:Dr.Cr. Delivery Truck21,000 Cash21,000 Monthly adjusting J/E: Depreciation Expense 300 Accumulated Depreciation 300 ($21,000 - $3,000) x 1/60 = $300 per mo. for 60 mos.)

12 Deferred Revenue - Cash received before revenue is earned l Examples: » Rent collected in advance » Subscriptions collected in advance » Gift certificates l Receipts are initially recorded as liabilities (unearned or refundable receipts) and recorded as revenues in future periods when earned.

13 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.)

14 Accrued Liability - Expense incurred before cash is paid l Examples: » Payroll » Taxes » Interest l Record expense (and corresponding liability) in period incurred; pay for it in a future period l No cash flow on recording, only when paid

15 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 4,000 Wages Expense24,000 Cash28,000

16 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. Cash20,000 Note Payable20,000 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)

17 Accrued Asset - R evenue earned before cash is received l Examples: » Rent » Interest l Record revenue (and corresponding receivable) in period earned; receive payment in a future period Revenue

18 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

19 Steps in the Accounting Cycle 1. Collect and analyze info 2. Journalize transactions 3. Post J/Es to general ledger 4. Prepare work sheet 5. Prepare financial statements 6. Record & post AJEs 7. Close the accounts

20 Revenues Normal balance Temporary Accounts Expenses Normal balance Dividends Normal balance $ XX Zero out temporary accounts to start accumulation of next period’s results. Close to income summary $ XX Close to income summary $ XX Close to retained earnings $ XX

21 Closing Entries (net loss) or net income closed to retained earnings Income Summary $xx from revenue accounts $xx from expense accounts

22 Appendix Accounting Tools: Work Sheets

23 Unadjusted Trial Balance columns Begin by filling in the trial balance accounts and amounts

24 Adjusting Entry columns Make adjustments. Formal journal entries are prepared later.

25 Adjusted Trial Balance columns Add or subtract adjustments for adjusted acct. balances

26 Income Statement columns Extend revenue and expense account balances to the income statement

27 Balance Sheet columns Extend asset, liability and equity accounts to the balance sheet

28 End of Chapter 4