1. Income Measurement and Accrual Accounting
Chapter 4
Income Measurement and
Accrual Accounting

2. Learning Objectives
LO1 Explain the significance of recognition and measurement in the preparation and use of financial statements. LO2 Explain the differences between the cash and accrual bases of accounting. LO3 Describe the revenue recognition principle and explain its application in various situations. LO4 Describe the matching principle and the various methods for recognizing expenses LO5 Identify the four major types of adjusting entries and prepare them for a variety of situations.

3. Learning Objectives (continued)
LO6 Explain the steps in the accounting cycle and the significance of each step. LO7 Explain why and how closing entries are made at the end of an accounting period. LO8 Understand how to use a work sheet as a basis for preparing financial statements (Appendix).

4. Module 1 Accrual Accounting Principles
The accrual basis of accounting provides information to users of the statements that a cash basis does not provide
The revenue recognition principle is important in various situations
The matching principle is used for recognizing expenses
Module 1

5. Accrual Accounting Principles
Recognition: process of recording an item as an asset, a liability, a revenue, an expense, or the like
Measurement: requires two choices to be made
The attribute to be measured
Historical cost
Current value
The unit of measure—yardstick
Money
Module 1: LO 1

6. Exhibit 4-1—Recognition and Measurement in Financial Statements
Module 1: LO 1

7. Cash and Accrual Bases of Accounting
Cash basis: revenues are recognized when cash is received and expenses are recognized when cash is paid
Accrual basis: revenues are recognized when a performance obligation is satisfied and expenses are recognized when incurred
Module 1: LO 2

8. Example 4-1—Comparing the Cash and Accrual Bases of Accounting
Module 1: LO 2

9. Exhibit 4-2—Comparing the Cash and Accrual Bases of Accounting
Module 1: LO 2

10. The Revenue Recognition Principle
Recognized in the income statement when a performance obligation is satisfied
Revenues: Inflows of assets or settlements of liabilities from:
Delivering or producing goods
Rendering services
Conducting other activities
Module 1: LO 3

11. Expense Recognition and the Matching Principle
Association of revenue of a period with all of the costs necessary to generate that revenue
Direct matching: associate revenues of a period with their costs
Indirect matching: associate costs with a particular period
Example: depreciation on building
Module 1: LO 4

12. Example 4-3—Comparing Three Methods for Matching Costs with Revenue
Module 1: LO 4

13. Module 2 Adjusting Entries
Various types of adjustments are made by companies and they are recorded in the accounting system as adjusting entries
Module 2

14. Types of Adjusting Entries
Made at the end of an accounting period
Types of adjusting entries:
Cash paid before expense is incurred (Deferred Expense)
Cash received before revenue is recognized (Deferred Revenue)
Expense incurred before cash is paid (Accrued Liability)
Revenue recognized before cash is received (Accrued Asset)
Module 2: LO 5

15. Accruals and Deferrals
Cash has been paid or received but expense or revenue has not yet been recognized
Deferred expense
An asset resulting from the payment of cash before the incurrence of expense
Deferred revenue
A liability resulting from the receipt of cash before the recognition of revenue
Module 2: LO 5

16. Deferred Expense Cash paid before expense is incurred Example:
Prepaid rent
Prepaid insurance
Office supplies
Property and equipment
Unexpired costs are assets
Written off and replaced with an expense as the costs expire
Module 2: LO 5

17. Example 4-4—Adjusting a Deferred Expense Account
Assume that on September 1, Nordstrom prepays $2,400 for an insurance policy for the next 12 months. The entry to record the prepayment is as follows:
Module 2: LO 5

18. Example 4-4—Adjusting a Deferred Expense Account (continued)
An asset account, Prepaid Insurance, is recorded because the company will receive benefits over the next 12 months
Because the insurance is for a 12-month period, $200 of benefits from the asset expires at the end of each month
Module 2: LO 5

19. Example 4-5—Recording Depreciation
Assume that on January 1, Nordstrom buys new store fixtures, for which it pays $5,000. The entry to record the purchase is as follows:
Module 2: LO 5

20. Example 4-5—Recording Depreciation (continued)
The adjustment to recognize depreciation is conceptually the same as the adjustment to write off Prepaid Insurance. The asset account is reduced and an expense is recognized
However, accountants normally use a contra account to reduce the total amount of long-term tangible assets by the amount of depreciation
Module 2: LO 5

21. Deferred Revenue Cash received before revenue is earned Example:
Insurance collected in advance
Subscriptions collected in advance
Gift certificates
Initially recorded as liabilities (unearned or refundable receipts) and recorded as revenues in future periods when earned
Module 2: LO 5

22. Example 4-6—Adjusting a Deferred Revenue Account
In Example 4-4 involving the purchase of an insurance policy, the insurance company received the cash paid by Nordstrom
The insurance company has a liability because it has taken cash from Nordstrom but has not yet performed the service to recognize the revenue
The revenue will be recognized with the passage of time. This is the entry on the books of the insurance company on September 1:
Module 2: LO 5

23. Example 4-6—Adjusting a Deferred Revenue Account (continued)
The account Insurance Collected in Advance is a liability
The adjusting entry at the end of each month accomplishes two purposes: it recognizes (1) the reduction in the liability and (2) the revenue each month
To decrease a liability with a debit and increase revenue with a credit:
Module 2: LO 5

24. Example 4-7—Adjusting a Gift Card Deferred Revenue Account
The entry that Nordstrom would make upon receipt of $100 for a gift card is as follows:
Module 2: LO 5

25. Example 4-7—Adjusting a Gift Card Deferred Revenue Account (continued)
Deferred Revenue is a liability
If the card is redeemed at a Nordstrom store on March 31, the entry on Nordstrom’s books on this date would be as follows:
Module 2: LO 5

26. Accrued Liability
Cash is paid after an expense is actually incurred rather than before its incurrence
Examples:
Payroll
Taxes
Utilities
Module 2: LO 5

27. Example 4-8—Adjusting an Accrued Liability for Wages
Assume that at one of its stores, Nordstrom pays a total of $280,000 in wages on every other Friday
Assume that the last payday was Friday, May 31
The next two paydays will be Friday, June 14, and Friday, June 28. The journal entry will be the same on each of these paydays:
Module 2: LO 5

28. Example 4-8—Adjusting an Accrued Liability for Wages (continued)
On a balance sheet prepared as of June 30, a liability must be recognized
Assume that the store is open seven days a week and that the daily cost is 1/14th of the biweekly amount of $280,000, or $20,000:
Module 2: LO 5

29. Example 4-8—Adjusting an Accrued Liability for Wages (continued)
Nordstrom will need to eliminate the liability of $40,000 for the last two days of wages recorded on June 30 because the amount has now been paid
An additional $240,000 of expense has been incurred for the $20,000 cost per day associated with the first 12 days in July
Finally, cash is reduced by $280,000, which represents the biweekly payroll
Module 2: LO 5

30. Example 4-9—Recording an Accrued Liability for Interest
Assume that Granger Company takes out a 9%, 90-day, $20,000 loan with its bank on March 1
Granger will repay the principal and interest on May 30
The entry on Granger’s books on March 1 follows:
Module 2: LO 5

31. Example 4-9—Recording an Accrued Liability for Interest (continued)
The amount of interest that must be recognized as expense at the end of March is one-third of $450 because one month of a total of three has passed
The adjusting entry for the month of March is as follows:
Module 2: LO 5

32. Example 4-9—Recording an Accrued Liability for Interest (continued)
The same adjusting entry is made at the end of April:
Module 2: LO 5

33. Example 4-9—Recording an Accrued Liability for Interest (continued)
The entry on Granger’s books on May 30 when it repays the principal and interest is as follows:
Module 2: LO 5

34. Accrued Asset Revenue earned before the receipt of cash
Example: Rent and interest are earned with the passage of time and require an adjustment if cash has not yet been received
Whenever a company records revenue before cash is received, receivable is increased and revenue is also increased
Module 2: LO 5

35. Example 4-10—Recording an Accrued Asset
Assume that Grand Management Company rents warehouse space to a number of tenants
Most of its contracts call for prepayment of rent for six months at a time
Its agreement with one tenant, however, allows the tenant to pay Grand $2,500 in monthly rent anytime within the first ten days of the following month
The adjusting entry on Grand’s books at the end of April, the first month of the agreement, is as follows:
Module 2: LO 5

36. Example 4-10—Recording an Accrued Asset
When the tenant pays its rent on May 7, the effect on Grand’s books is as follows:
Module 2: LO 5

37. Exhibit 4-3—Accruals and Deferrals
Module 2 : LO 5

38. Exhibit 4-4—Unadjusted Trial Balance
Module 2 : LO 5

39. Exhibit 4-5—Adjusted Trial Balance
Module 2: LO 5

40. Module 3 Accounting Cycle and Closing Entries
Various steps in the accounting cycle lead up to a set of financial statements
Module 3

41. The Accounting Cycle
Series of steps performed each period and culminating with the preparation of a set of financial statements
Module 3: LO 6

42. Exhibit 4-6—Steps in the Accounting Cycle
Module 3: LO 6

43. The Use of a Work Sheet
Device used at the end of the period to gather the information needed to prepare financial statements without actually recording and posting adjusting entries
Module 3: LO 6

44. Closing Entries Made at the end of an accounting period
Serve two purposes:
Return the balance in all nominal accounts to zero
Transfer the net income or loss and the dividends to Retained Earnings
Module 3: LO 7

45. Real and Nominal Accounts
Real accounts: balance sheet accounts
Permanent
Not closed at the end of the period
Nominal accounts: revenue, expense, and dividend accounts
Temporary
Closed at the end of the period
Module 3: LO 7

46. The Closing Process
Debit all revenue accounts and credit the sum to Income Summary—single entry is made
Credit all expense accounts and debit the sum to Income Summary—single entry is made
Debit or credit Income Summary depending on balance
Debit if credit balance, then credit Retained Earnings
Credit if debit balance, then debit Retained Earnings
A credit is made to close the Dividends account with an offsetting debit to Retained Earnings
Module 3: LO 7

47. Example 4-12—Preparing Closing Entries
Module 3: LO 7

48. Interim Financial Statements
Financial statements prepared monthly, quarterly, or at other intervals less than a year in duration
Module 3: LO 7

49. Module 4 Accounting Tools: Work Sheets
A work sheet can expedite the preparation of financial statements at the end of the period
Module 4

50. Accounting Tools: Work Sheets
Used to aid in preparation of the statements at the end of a period
The format for a work sheet includes two columns each (debits and credits) for:
the unadjusted trial balance
the adjustments
the adjusted trial balance
the income statement
the balance sheet
Module 4: LO 8

51. Review
LO1 Explain the significance of recognition and measurement in the preparation and use of financial statements.
Determining which economic events should be recognized and how they should be measured is critical for accounting information to be useful.
Recognition drives how and when the effects of economic events are described in the financial statements.
Measurement involves deciding on the attribute of an economic event that must be measured and the appropriate unit of measure.

52. Review
LO2 Explain the differences between the cash and accrual bases of accounting.
Cash and accrual bases are two alternatives used to account for transactions or economic events. They differ in the timing of when revenues and expenses are recognized.
Under the accrual method, which is the focus of this text, revenues are recognized when a performance obligation is satisfied and expenses are recognized when incurred.
By contrast, under the cash method, revenues are recognized when cash is received and expenses are recognized when cash is paid.
LO3 Describe the revenue recognition principle and explain its application in various situations.
Revenues are inflows of assets (or reductions of liabilities), generally from providing goods or services to customers.
Revenues are recognized when a performance obligation is satisfied.

53. Review
LO4 Describe the matching principle and the various methods for recognizing expenses
The matching principle attempts to associate expenses with the time periods in which the expenditures help generate revenues.
This principle is particularly important with expenditures for items that last for more than one accounting period. An example is the depreciation of a building.

54. Review
LO5 Identify the four major types of adjusting entries and prepare them for a variety of situations.
Adjusting entries are made at the end of an accounting period to update revenue or expense accounts in accordance with the revenue recognition and matching principles.
There are four basic categories of adjusting entries:
Adjustments where cash is paid before expenses are incurred—deferred expenses.
Adjustments where cash is received before revenues are recognized—deferred revenues.
Adjustments where expenses are incurred before cash is paid—accrued liabilities.
Adjustments where revenues are recognized before cash is received—accrued assets.

55. Review
LO6 Explain the steps in the accounting cycle and the significance of each step.
The accounting cycle involves seven steps that are repeated each period. (See Exhibit 4-6.)
Collecting and analyzing data and journalizing transactions occur on a continuous basis.
Periodically, transactions are posted to accounts in the ledger.
At the end of the period, a work sheet is prepared, financial statements are prepared, adjusting entries are recorded and posted, and accounts are closed.
LO7 Explain why and how closing entries are made at the end of an accounting period.
Journal entries that close the nominal (temporary) accounts achieve two important objectives:
They return the balance of all nominal accounts to zero so that the accounts are ready to record activity for the next accounting period.
They transfer net income (loss) and dividends to Retained Earnings.

56. Review
LO8 Understand how to use a work sheet as a basis for preparing financial statements (Appendix).
A work sheet is a useful device for organizing the information necessary to prepare financial statements without going through the formal process of recording and posting adjusting entries.
The format for a work sheet includes two columns each (debits and credits) for the unadjusted trial balance, the adjustments, the adjusted trial balance, the income statement, and the balance sheet.

57. End of Chapter 4