Income Measurement and Accrual Accounting Chapter 4 Income Measurement and Accrual Accounting

Recognition and Measurement in 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 the Matching 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 Cycle 30 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 sheet 30 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 Statements 30 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