1. 7/e PowerPoint Author: Catherine Lumbattis COPYRIGHT © 2011 South-Western/Cengage Learning 4 Income Measurement and Accrual Accounting

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 economic effects of the item on the entity...but at current value or historical cost? LO1

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 LO2

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

6. Matching Principle Directly e.g., Inventory e.g., Buildings e.g., Utilities Match expenses with associated revenues Indirectly over period they provide benefits Simultaneously upon their acquisition LO4

7. Expense Recognition Income Statement 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) Inventory Supplies Prepaid assets l

8. Types of Adjusting Entries RECOGNIZE REVENUE OR EXPENSES BEFORE OR AFTER CASH IS EXCHANGED Deferred expense Accrued liability Accrued asset Deferred revenue LO5

9. 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

10. Prepay rent on office space for one year on September 1 Initial journal entry: 9/1Prepaid Insurance2,400 Cash2,400 Monthly adjusting journal entry: 9/30Insurance Expense 200 Prepaid Insurance 200 ($2,400 annual × 1/12 = $200 per month for 12 months) Deferred Expense Example #1

11. Deferred Expense Example #2 Initial journal entry: 1/1 Store fixtures5,000 Cash 5,000 Monthly adjusting journal entry: 1/31 Depreciation Expense 75 Accumulated Depreciation 75 ($5,000 – $500) × 1/60 = $75 per month for 60 months) Purchase new store fixtures on January 1 for $5,000. Estimated useful life is 5 years (60 months); estimated salvage value is $500

12. 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

13. Deferred Revenue Example Received $2,400 for an insurance policy in advance on September 1 Initial journal entry: 9/1 Cash 2,400 Insurance Collected in Advance 2,400 Monthly adjusting journal entry: 9/30Insurance Collected in Advance 200 Insurance Revenue 200 ($2,400 annual × 1/12 = $200 per month for 12 months)

14. 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

15. Accrued Liability Example #1 At end of month, between pay periods: Wages Expense 40,000 Wages Payable 40,000 Next payday: Wages Payable 40,000 Wages Expense 240,000 Cash 280,000 Pay biweekly wages of $280,000

16. Accrued Liability Example #2 Initial journal entry: 3/1Cash 20,000 Note Payable 20,000 Monthly adjusting journal entry: 3/31Interest Expense 150 Interest Payable 150 ($20,000 principal × 9% × 3/12 = $450 for 3 months or $450/3 = $150 per month) On March 1, assume a 9%, 90-day, $20,000 loan is taken out with a bank

17. 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

18. Accrued Asset Example First day of the month: Rent Receivable 2,500 Rent Revenue 2,500 Upon receipt of cash: Cash 2,500 Rent Receivable 2,500 Rent payment of $2,500 due within first 10 days of month

19. Adjusting Entry Summary Examples:  Deferred Expense cash received before expense is incurred  Deferred Revenue cash received before revenue is earned  Accrued Liability expense incurred before cash is paid  Accrued Asset revenue is earned before cash is received

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

21. The Closing Process Purpose:  To return the balance of revenue, expense, and dividend accounts to zero to begin the next period  to transfer the net income of the period to Retained Earnings

22. Revenues Normal balance Nominal Accounts Expenses Normal balance Dividends Normal balance $ XX Zero out nominal accounts to start accumulation of next period’s results Close to Income Summary $ XX Close to Income Summary $ XX Close to Retained Earnings $ XX LO7

23. Closing Entries (Net loss) or net income closed to Retained Earnings Income Summary $XX from revenue accounts $XX from expense accounts

24. Appendix Accounting Tools: Work Sheets

25. Unadjusted Trial Balance Columns Begin by filling in the trial balance accounts and amounts LO8

26. The Adjusting Entries Columns Make adjustments; formal journal entries are prepared later

27. Adjusted Trial Balance Columns Add or subtract adjustments for adjusted account balances

28. The Income Statement Columns Extend revenue and expense account balances to the income statement

29. The Balance Sheet Columns Extend asset, liability, and equity accounts to the balance sheet

30. End of Chapter 4