Gary A. Porter and Curtis L. Norton Using Financial Accounting Information: The Alternative to Debits and Credits Fifth Edition Gary A. Porter and Curtis L. Norton Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Recognition and Measurement Recognition: formally recording an item in the financial statements of an entity “I know I need to record this...” “...but at current value or historical cost?” Measurement: quantification of the economic effects of the item on the entity LO1

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

Accrual basis statement Cash basis statement Accrual basis statement Income Statement Net income: $ 7,000 Statement of Cash Flows Cash flows from operating activities: $(4,000) What accounts for the difference?

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

Expense Recognition Balance Sheet Income Statement ASSETS: EXPENSES: PP&E Intangibles ASSETS: EXPENSES: when sold Cost of goods sold Inventory Supplies Prepaid assets as used Supplies expense Insurance expense Rent expense over period they provide benefits Depreciation expense Amortization expense Other expenses (as incurred) LO4

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

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

Deferred Expense Example Prepay $2,400 for insurance for one year on Sept 1 To record payment: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Prepaid Ins 2,400 Cash (2,400) Monthly adjustment: Prepaid Ins (200) Insurance Expense (200) ($2,400 annual × 1/12 = $200 per month for 12 months)

Deferred Expense Example Purchase furniture on January 1 for $5,000. Estimated useful life is 7 years (84 months); estimated salvage value is $800 Purchase of furniture: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Furniture 5,000 Cash (5,000) Monthly adjustment: Accumulated Depreciation Expense depreciation (50) (50) ($5,000 – $800) × 1/84 = $50 per month for 84 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 on September 1 To record collection: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Cash = Insurance collected 2,400 in Advance 2,400 Monthly adjusting journal entry: Insurance collected Insurance expense in Advance (200) (200) ($2,400 annual × 1/12 = $200 per month for 12 months) Deferred Revenue Example

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 Pay biweekly wages of $28,000 At end of month, between pay periods: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Wages payable + Wages expense 4,000 (4,000) Next payday: Cash = Wages payable + Wages expense (28,000) (4,000) (24,000)

Accrued Liability Example On March 1, assume a 9%, 90-day, $20,000 loan is taken out with a bank To record borrowing: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Cash = Notes Payable 20,000 20,000 Monthly adjustment: Interest Payable + Interest Expense 150 (150) ($20,000 principal × 9% × 3/12 = $450 for 3 months or $450/3 = $150 per month)

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 of the month: Rent payment of $2,500 due within first 10 days of month First of the month: Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Rent receivable Rent revenue 2,500 = 2,500 Upon receipt of cash: Cash 2,500 Rent receivable (2,500)

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

Net income (or net loss) Nominal Accounts Serve 2 important purposes: Zero out nominal accounts to start accumulation of next period’s results Transfer Net income (or net loss) and dividends to the Retained Earnings account

End of Chapter 4