Chapter 4 Income Measurement and Accrual Accounting

Chapter 4

Income Measurement andAccrual Accounting

Recognition and Measurementin Financial Statements

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 Choice 1: The attribute to be measured• Historical cost• Current value

Choice 2: The unit of measure—yardstick• Money

LO 1

Exhibit 4.1—Recognition and Measurement in Financial Statements

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 earned and expenses are recognized when incurred

LO 2

Example 4.1—Comparing the Cash and Accrual Bases of Accounting

Exhibit 4.2—Comparing the Cash and Accrual Bases of Accounting

The Revenue Recognition Principle

Recognized in the income statement when they are realized, or realizable, and earned

Revenues: Inflows of assets or settlements of liabilities Delivering or producing goods Rendering services Conducting other activities

LO 3

Expense Recognition and theMatching 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

Expenses incurred in two different ways: From the use of an asset From the recognition of a liability

LO 4

Example 4.3—Comparing Three Methods for Matching Costs with Revenue

Adjusting Entries Made at the end of an accounting period internal transactions and do not affect the Cash

account Adjustment of either an asset or a liability with a

corresponding change in revenue or expense Types of adjusting entries:

Deferred expense Deferred revenue Accrued liability Accrued asset

LO 5

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

Example 4.4—Adjusting a Deferred Expense Account

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

Example 4.6—Adjusting a Deferred Revenue Account

Accrued Liability

Cash is paid after an expense is actually incurred rather than before its incurrence

Examples: Payroll Taxes Utilities

Example 4.8—Recording an Accrued Liability for Wages

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

Example 4.10—Recording an Accrued Asset

30 adjustment to recognize insurance expense:

Accruals and Deferrals

30 adjustment to recognize insurance expense:

The Accounting Cycle30 adjustment to recognize insurance expense: Series of steps performed each period and

culminating with the preparation of a set of financial statements

LO 6

Exhibit 4.5—Steps in the Accounting Cycle

Work sheet30 adjustment to recognize insurance expense: Device used at the end of the period to gather

the information needed to prepare financial statements without actually recording and posting adjusting entries

Closing Entries

Made at the end of an accounting period Return the balance in all nominal accounts to

zero Transfer the net income or net loss and the

dividends of the period to the Retained Earnings account

Real and Nominal accounts

Real accounts: balance sheet accounts Permanent in nature Not closed at the end of the period

Nominal accounts: revenue, expense, and dividend accounts Temporary in nature Closed at the end of the period

Closing Process

All revenue accounts is credited to Income Summary—single entry is made

All expense accounts is credited to Income Summary—single entry is made

Credit balance in the Income Summary account is transferred to Retained Earnings

A credit is made to close the Dividends account with an offsetting debit to Retained Earnings

Interim Financial Statements30 adjustment to recognize insurance expense: Financial Statements prepared monthly,

quarterly or at other intervals less than a year in duration

Prepared for internal use

End of Chapter 4