7/e

PowerPoint Author: Catherine Lumbattis

COPYRIGHT © 2011 South-Western/Cengage Learning

4

Income Measurement

and Accrual

Accounting

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

Cash vs. Accrual Basis

Cash basis: revenues and expenses arerecorded only when cash is received or paid

Accrual basis: revenues are recognized whenearned; expenses are recognized when incurred

LO2

Cash basisstatement

Accrual basis statement

Statement ofCash Flows

Cash flows from operating activities:

$(4,000)

IncomeStatement

Net income: $ 7,000

What accounts for the difference?

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

Matching Principle

Directly

e.g., Inventory e.g., Buildings e.g., Utilities

Match expenses with associated revenues

Indirectly over period they

provide benefits

Simultaneouslyupon their acquisition

LO4

Expense RecognitionIncome Statement

PP&EIntangibles

as used

Balance Sheet

when sold

over period they provide benefits

ASSETS: EXPENSES:Cost of goods sold

Supplies expenseInsurance expenseRent expense

Depreciation expenseAmortization expenseOther expenses

(as incurred)

Inventory

SuppliesPrepaid assets

l

Types of Adjusting Entries

RECOGNIZE REVENUE OR

EXPENSES BEFORE OR AFTER

CASH IS EXCHANGED

Deferred expense

Accrued liability

Accrued asset

Deferredrevenue

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

Prepay rent on office space for one year on September 1Initial journal entry:9/1 Prepaid Insurance 2,400

Cash 2,400Monthly adjusting journal entry:9/30 Insurance Expense 200

Prepaid Insurance 200($2,400 annual × 1/12 = $200 per month for 12 months)

Deferred Expense Example #1

Deferred Expense Example #2

Initial journal entry:1/1 Store fixtures 5,000

Cash 5,000Monthly 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

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 on September 1

Initial journal entry:9/1 Cash 2,400

Insurance Collected in Advance 2,400

Monthly adjusting journal entry:

9/30 Insurance Collected in Advance 200Insurance 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

At end of month, between pay periods: Wages Expense 40,000

Wages Payable 40,000

Next payday:Wages Payable 40,000Wages Expense 240,000

Cash 280,000

Pay biweekly wages of $280,000

Accrued Liability Example #2

Initial journal entry:3/1 Cash 20,000

Note Payable 20,000Monthly adjusting journal entry:3/31 Interest 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

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

First day of the month:Rent Receivable 2,500

Rent Revenue 2,500Upon receipt of cash:Cash 2,500

Rent Receivable 2,500

Rent payment of $2,500 due within first 10 days of month

Adjusting Entry SummaryExamples: 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

Steps in the Accounting Cycle1. Collect and analyze info

2. Journalizetransactions

3. Post transactions togeneral ledger

4. Preparework sheet

5. Preparefinancial

statements

6. Record andpost adjusting

entries

7. Close theaccounts

LO6

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

RevenuesNormalbalance

Nominal AccountsExpenses

Normalbalance

DividendsNormalbalance

$ XX $ XX

$ XX

Zero outnominal accounts

to start accumulation of next period’s

results

Close to Income

Summary

$ XX

Close to Income

Summary

$ XX

Close to RetainedEarnings

$ XXLO7

Closing Entries

(Net loss) or net incomeclosed to Retained Earnings

Income Summary$XX

from revenueaccounts

$XX from expense

accounts

AppendixAccounting Tools:

Work Sheets

Unadjusted Trial Balance Columns

Begin by filling in the trial balance accounts and amounts

LO8

The Adjusting Entries Columns

Make adjustments; formal journal entries are prepared later

Adjusted Trial Balance ColumnsAdd or s

ubtract

adjustments

for a

djusted

account b

alances

The Income Statement Columns

Extend revenue and expense account balances to the income statement

The Balance Sheet Columns

Extend asset, liability, and equity accounts to the balance sheet

End of Chapter 4