Chapter 4 Income Measurement and Accrual Accounting Using Financial Accounting Information: The Alternative to Debits and Credits, 6/e by Gary A. Porter and Curtis L. Norton Copyright © 2009 South-Western, a part of Cengage Learning.

Recognition and Measurement I know I need to record this... Recognition: formally recording an item in the financial statements of an entity 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 are recorded only when cash is received or paid Accrual basis: revenues are recognized when earned; expenses are recognized when incurred LO2

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

Revenue Recognition Principle Revenue is recognized when realized and earned—usually at point of sale Exceptions: Long-term contracts Franchises Commodities Installment sales Rent and interest LO3

Expense Recognition Balance Sheet Income Statement ASSETS: EXPENSES: PP&E Intangibles ASSETS: EXPENSES: when sold Cost of goods sold Inventory Supplies Prepaid assets as used Supplies expense Insurance expense Rent expense over period they provide benefits Depreciation expense Amortization expense Other expenses (as incurred) LO4

Match expenses with associated revenues Matching Principle Match expenses with associated revenues Directly Indirectly over period they provide benefits Simultaneously upon their acquisition e.g., Inventory e.g., Buildings e.g., Utilities

Types of Adjusting Entries Deferred expense Accrued liability RECOGNIZE REVENUE OR EXPENSES BEFORE OR AFTER CASH IS EXCHANGED Accrued asset Deferred revenue 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

Deferred Expense Example #1 Prepay $2,400 for insurance for one year on September 1 Initial journal entry: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity Prepaid Insurance 2400 Cash (2400) Monthly adjusting journal entry: Prepaid Insurance (200) Insurance Expense (200) ($2,400 annual × 1/12 = $200 per month for 12 months)

Deferred Expense Example #2 Purchase new store fixtures on January 1 for $5,000; estimated useful life is 5 years 60 months); estimated salvage value is $500 Deferred Expense Example #2 Purchase of Store fixtures: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity Store fixtures 5,000 Cash (5,000) Monthly adjusting journal entry: Accumulated Depreciation Expense Depreciation (75) (75) ($5,000 – $500) × 1/60 = $75 per month for 60 months)

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: Initial journal entry: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity Cash 2,400 Insurance Collected in Advance 2,400 Monthly adjusting journal entry: Insurance Collected in Advance (200) Rent 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 #1 Biweekly wages are $280,000 At end of month, between pay periods: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity Wages Payable Wages Expense 40,000 (40,000) Next payday: Cash Wages Payable Wages Expense (280,000) (40,000) (240,000)

Accrued Liability Example #2 On March 1, assume a 9%, 90-day, $20,000 loan is taken Initial journal entry: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues -- Expenses Equity Cash Note Payable 20,000 20,000 Monthly adjusting journal entry: Interest Payable Interest Expense 150 (150) ($20,000 principal × 9% × 1/12 = $150/month )

Accrued Liability Example #2 Payment of note and interest: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity Cash (20450) Notes Payable (20000) Interest Expense (150) Interest Payable (300)

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 Rent payment of $2,500 due within first 10 days of month First day of the month: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity Rent Receivable Rent Revenue 2,500 2,500 Upon receipt of cash: Cash 2,500 Rent Receivable (2,500)

Steps in the Accounting Cycle 1. Collect and analyze info 7. Close the accounts 2. Journalize transactions 6. Record and post adjusting entries 3. Post transactions to general ledger 5. Prepare financial statements 4. Prepare work sheet LO6

The Closing Process Real Accounts: Balance Sheet accounts are permanent accounts and are never closed Balances are carried over from one period to the next Nominal Accounts: These are temporary accounts These accounts are closed at the end of the period and these balances are not carried over from one period to another Revenues, Expenses and Dividends Zero out nominal accounts to start accumulation of next period’s results

Closing Entries Closing Entries serve two purposes: To return the balances in all temporary or nominal accounts to zero to start the next accounting period To transfer the net income (or net loss) and the dividends of the period to the Retained Earnings account

Interim Statements or at other intervals less than a year Financial statements prepared monthly, quarterly, or at other intervals less than a year Used for internal purposes

End of Chapter 4