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University of Evansville - Accounting 210 Chapter 4
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4
Income Measurement
and Accrual
Accounting
RecognitionThe process of formally recording or incorporating an item into the financial statements of an entity as an asset, a liability, a revenue, an expense, and the like. Sales
MeasurementHistorical Cost – simplest and most verifiableCurrent Value – the estimated value of the asset
Reliability vs. Relevance
Because of its objective nature, historical cost is the attribute used to measure many non-current assets.
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 or realizable and earned—usually at time of sale
LO3
Expense Recognition 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 Adjustments
RECOGNIZE REVENUE OR
EXPENSES BEFORE OR AFTER
CASH IS EXCHANGED
Deferred expense
Accrued liability
Accrued asset
Deferredrevenue
LO5
Adjustments 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
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 $2,400 for insurance for one year on September 1
Deferred Expense Example
September 30 adjustment to recognize insurance expense:
Deferred Expense Example
$2,400 / 12 months = $200 /month
Deferred Expense Example
Purchase of Store fixtures:
Purchase new store fixtures on January 1 for $5,000; estimated useful life is 5 years 60 months); estimated salvage value is $500
Deferred Expense Example Monthly adjustment:
($5,000 – $500) × 1/60 = $75 per month for 60 months)
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:
Deferred Revenue Example Monthly adjustment:
($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
Biweekly wages are $280,000
Accrued Liability Example At end of month, between pay periods:
Accrued Liability Example Next payday:
Accrued Liability Example
On March 1, assume a 9%, 90-day, $20,000 loan is taken
Accrued Liability Example
Monthly adjustment:
($20,000 principal × 9% × 1/12 = $150/month )
Accrued Liability ExamplePayment of principal and interest on May 30
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 Rent payment of $2,500 due within first 10 days of month
Accrued Asset Example Upon receipt of cash:
Adjustments 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
Ethics and Accrual Accounting
Accountants must remember their primary responsibility is preparing financial statements is to portray the affairs of the company accurately to various outside users. Bankers, stockholders, and others rely on the accountant to serve their best interests.
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 Use of a Worksheet Used at the end of the period to gather the information needed to prepare financial statements without actually recording and posting entries The worksheet is not a financial statement Useful device to organize the information needed to prepare the financial statements at the end of the period
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
Interim Statements Financial Statements prepared monthly, quarterly or at other intervals less than a year
Used for internal purposes