4 Introduction to Financial Accounting Information, 7/e Income Measurement and Accrual Accounting 4 PowerPoint Author: Catherine Lumbattis COPYRIGHT © 2011 South-Western/Cengage Learning

Recognition and Measurement I know I need to record this... Recognition: formally recording an item in the financial statements of an entity 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 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 time of sale Exceptions: Long-term contracts Franchises Commodities Installment sales Rent and interest LO3

Match expenses with associated revenues Matching Principle Match expenses with associated revenues Directly Indirectly over period they provide benefits Simultaneously upon their acquisition e.g. Inventory e.g. Buildings e.g. Utilities LO4

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 Depreciation expense Amortization expense over period they provide benefits l Other expenses (as incurred)

RECOGNIZE REVENUE OR EXPENSES BEFORE OR AFTER CASH IS EXCHANGED Types of Adjustments Deferred expense Accrued liability 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 September 1

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

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 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 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 Adjustments Summary

Steps in the Accounting Cycle 1. Collect and analyze info 7. Close the accounts 2. Journalize transactions 6. Record and post adjusting entries 3. Post transactions to general ledger 5. Prepare financial statements 4. Prepare work sheet 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 (or loss) and dividends of the period to Retained Earnings

End of Chapter 4