1. 1 Chapter 4 Income Measurement and Accrual Accounting Financial Accounting, Alternate 4e by Porter and Norton

2. 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. 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. 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. 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. 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. 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. 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. 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. 10 Deferred Expense Example #1 – Prepay rent on office space for one year on Sept. 1 Initial transaction: Assets = Liab. + O/E + Rev. – Exp. Prepaid Rent 2,400 Cash(2,400) Monthly adjustment: Assets = Liab. + O/E + Rev. – Exp. Prepaid Rent (200)Rent Exp. (200)

11. 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 transaction: Assets = Liab. + O/E + Rev. – Exp. Delivery Truck 21,000 Cash (21,000) Monthly adjustment: Assets = Liab. + O/E + Rev. – Exp. Acc. Depr. (300)Depr. Exp. (300)

12. 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. 13 Initial transaction: Assets = Liab. + O/E + Rev. – Exp. Cash 2,400 Rent Collected in Advance 2,400 Monthly adjustment: Assets = Liab. + O/E + Rev. – Exp. Rent Collected Rent Rev. 200 in Advance (200) Deferred Revenue Example #1 - Receive $2,400 for twelve months rent in advance

14. 14 Initial transaction: Assets = Liab. + O/E + Rev. – Exp. Cash 6,000 Subs. Collected in Advance 6,000 Monthly adjustment: Assets = Liab. + O/E + Rev. – Exp. Subs. Collected Subs. Rev. 500 in Advance (500) Deferred Revenue Example #2 - Sell 500 1-yr. subscriptions at $12 each

15. 15 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

16. 16 At end of month, between pay periods: Assets = Liab. + O/E + Rev. – Exp. Wages Pay. 4,000 Wages Exp. (4,000) Next payday: Assets = Liab. + O/E + Rev. – Exp. Cash (28,000) Wages Pay. (4,000)Wages Exp. (24,000) Accrued Liability Example #1 - Pay biweekly wages of $28,000

17. 17 Initial transaction: Assets = Liab. + O/E + Rev. – Exp. Cash 20,000 Notes Pay. 20,000 Monthly adjustment: Assets = Liab. + O/E + Rev. – Exp. Interest Pay. 300 Interest Exp. (300) Accrued Liability Example #2 - Borrow $20,000 for three months. Principal plus 9% interest due at end of loan period.

18. 18 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

19. 19 First day of the month: Assets = Liab. + O/E + Rev. – Exp. Rent Rec. 2,500 Rent Rev. 2,500 Upon receipt of cash: Assets = Liab. + O/E + Rev. – Exp. Cash 2,500 Rent Rec. (2,500) Accrued Asset Example – Rent payment due within first 10 days of month

20. 20 Ethical Considerations The accountant’s primary responsibility is to accurately portray the affairs of the company in the financial statements When to recognize expenses? When to recognize revenue?

21. 21 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 Continuously Periodically End of the period

22. 22 Closing Entries net income or (net loss) closed to Retained Earnings Revenue accounts $ xx Expense accounts (xx) Return all balances in temporary accounts to zero for the next period

23. 23 End of Chapter 4