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 Adjustments 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 $2,400 for insurance for one year on September 1 Deferred Expense Example

11. September 30 adjustment to recognize insurance expense: Deferred Expense Example $2,400 / 12 months = $200 /month

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:

14. Deferred Revenue Example Monthly adjustment: ($2,400 annual × 1/12 = $200 per month for 12 months)

15. 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

16. Accrued Liability Example Biweekly wages are $280,000

17. Accrued Liability Example At end of month, between pay periods:

18. Accrued Liability Example Next payday:

19. 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

20. Accrued Asset Example Rent payment of $2,500 due within first 10 days of month

21. Accrued Asset Example Upon receipt of cash:

22. Adjustments 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

23. 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

24. 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 (or loss) and dividends of the period to Retained Earnings

25. End of Chapter 4