1. 1 Keeping Score: Bases of Economic Measurement CHAPTER F6 © 2007 Pearson Custom Publishing

2. 2 Explain the difference between reality and the measurement of reality. © 2007 Pearson Custom Publishing Learning Objective 1:

3. 3 What is “Reality” in Business? A firm performs the following functions: A firm performs the following functions: 1.. it operates to generate revenues, 2.. it invests resources to enable operations, 3.. it finances its operations and investments with both internal and external sources, and 4.. it makes decisions. © 2007 Pearson Custom Publishing

4. 4 Measurement of Reality An accounting system needs to record the reality of each business event. An accounting system needs to record the reality of each business event. Unfortunately, there is often a distortion between the reality and the measurement of reality. Unfortunately, there is often a distortion between the reality and the measurement of reality. No matter how accurately the measurement of reality reflects reality, it is not that reality. No matter how accurately the measurement of reality reflects reality, it is not that reality. © 2007 Pearson Custom Publishing

5. 5 Periodic Measurement Problems Many differences between “reality” and the “measurement of reality” stem from the accountants need to measure activities for a specific period (month, quarter, year, etc.). Many differences between “reality” and the “measurement of reality” stem from the accountants need to measure activities for a specific period (month, quarter, year, etc.). If we didn’t apply this assumption of “periodicity,” then we would not be able to prepare monthly financial statements or annual reports. If we didn’t apply this assumption of “periodicity,” then we would not be able to prepare monthly financial statements or annual reports. © 2007 Pearson Custom Publishing

6. 6 Periodic Measurement Problems It is the “cut-off” at the end of the period that causes those problems. Accountants are basically required to take the entire life-span of a business and chop it up into little chunks. It is the “cut-off” at the end of the period that causes those problems. Accountants are basically required to take the entire life-span of a business and chop it up into little chunks. © 2007 Pearson Custom Publishing

7. 7 Periodicity Example Assume you are a house painter. On Dec. 20, you agree to paint a house for a total fee of $3,000. You begin the work on December 28 and you finish the job on January 6. The customer pays you the full amount on Jan. 7. Assume you are a house painter. On Dec. 20, you agree to paint a house for a total fee of $3,000. You begin the work on December 28 and you finish the job on January 6. The customer pays you the full amount on Jan. 7. When should the $3,000 be shown as a revenue? (Let’s assume that you were about 1/3 finished with the job as of December 31.) When should the $3,000 be shown as a revenue? (Let’s assume that you were about 1/3 finished with the job as of December 31.) © 2007 Pearson Custom Publishing

8. 8 Apply the criteria for revenue and expense recognition under the cash basis of accounting to determine periodic net income. © 2007 Pearson Custom Publishing Learning Objective 2:

9. 9 Revenue and Expense Recognition When accountants say that a revenue or expense has been recognized, they mean that: When accountants say that a revenue or expense has been recognized, they mean that: 1 the revenue or expense has been recorded in the accounting records (i.e., “the books”), and 2 that it is being reported on the financial statements of the business. © 2007 Pearson Custom Publishing

10. 10 Revenue and Expense Recognition There is no perfect way to determine when recognition should take place, thus we have to follow certain accounting rules and conventions. There is no perfect way to determine when recognition should take place, thus we have to follow certain accounting rules and conventions. There are two basic approaches to determining when to recognize revenues and expenses. These are two different ways to measure reality. There are two basic approaches to determining when to recognize revenues and expenses. These are two different ways to measure reality. © 2007 Pearson Custom Publishing

11. 11 Determine periodic net income applying the rules of revenue and expense recognition required by accrual accounting. © 2007 Pearson Custom Publishing Learning Objective 3:

12. 12 Two Bases of Economic Measurement Cash Basis: The easy way! When cash comes in, it’s a revenue; when cash goes out, it’s an expense. (Some exceptions apply!) Cash Basis: The easy way! When cash comes in, it’s a revenue; when cash goes out, it’s an expense. (Some exceptions apply!) Accrual Basis: Recognize revenues when “earned” and expenses when “incurred.” The timing of the related cash inflow or outflow is irrelevant. Accrual Basis: Recognize revenues when “earned” and expenses when “incurred.” The timing of the related cash inflow or outflow is irrelevant. © 2007 Pearson Custom Publishing

13. 13 Cash Basis Financial Statements To prepare financial statements using the cash basis of accounting: To prepare financial statements using the cash basis of accounting: cash inflows (except from owners and creditors) are considered revenues, and cash inflows (except from owners and creditors) are considered revenues, and cash outflows (except distributions to owners and repayments of principal to creditors) are considered expenses. cash outflows (except distributions to owners and repayments of principal to creditors) are considered expenses. © 2007 Pearson Custom Publishing

14. 14 Cash Basis Example Assume the following facts: You invested $25,000 to start a proprietorship, You invested $25,000 to start a proprietorship, During your first month of business, you had: During your first month of business, you had: sales of inventory to customers totaling $20,000 (NOTE: $5,000 of the sales were credit sales and were not collected in the first month.) sales of inventory to customers totaling $20,000 (NOTE: $5,000 of the sales were credit sales and were not collected in the first month.) purchases of inventory totaling $20,000 for which you paid cash to the supplier (one-half is still on hand), (continued on next slide) purchases of inventory totaling $20,000 for which you paid cash to the supplier (one-half is still on hand), (continued on next slide) © 2007 Pearson Custom Publishing

15. 15 Cash Basis Example In your first month you also: In your first month you also: had employees that earned a total of $5,000. Because payday doesn’t coincide with the end of the month, you have only paid them $3,000 of the amount earned. had employees that earned a total of $5,000. Because payday doesn’t coincide with the end of the month, you have only paid them $3,000 of the amount earned. paid for a one-year insurance premium of $2,400. paid for a one-year insurance premium of $2,400. incurred other operating expenses (utilities, etc.) totaling $2,000 which were all paid with cash. incurred other operating expenses (utilities, etc.) totaling $2,000 which were all paid with cash. purchased equipment and fixtures at a cost of $12,000. You believe these assets will last 10 years. purchased equipment and fixtures at a cost of $12,000. You believe these assets will last 10 years. borrowed $5,000 from the bank on the last day of the month because you were low on cash. borrowed $5,000 from the bank on the last day of the month because you were low on cash. © 2007 Pearson Custom Publishing

16. 16 Cash Basis Analysis Analyzing this data according to the cash basis of accounting: Analyzing this data according to the cash basis of accounting: you had revenues for the cash collected from customers, but not for the cash you invested in the business, and not for the cash from the bank loan. you had revenues for the cash collected from customers, but not for the cash you invested in the business, and not for the cash from the bank loan. you had expenses equal to the cash paid for all of the different purchases, the wages paid, and the other operating costs. you had expenses equal to the cash paid for all of the different purchases, the wages paid, and the other operating costs. © 2007 Pearson Custom Publishing

17. 17 Cash Basis Income Statement © 2007 Pearson Custom Publishing

18. 18 Cash Basis Statement of Capital © 2007 Pearson Custom Publishing

19. 19 Cash Basis Balance Sheet © 2007 Pearson Custom Publishing

20. 20 Accrual Basis Financial Statements The accrual basis of accounting does not focus on the timing of the cash flows, but rather on the timing of the event that results in a revenue or expense. The accrual basis of accounting does not focus on the timing of the cash flows, but rather on the timing of the event that results in a revenue or expense. Definition of accrue: To come into being as a legally enforceable claim. Definition of accrue: To come into being as a legally enforceable claim. The key is to determine when to recognize revenues and expenses for a business. The key is to determine when to recognize revenues and expenses for a business. © 2007 Pearson Custom Publishing

21. 21 Explain the concept of matching and describe how it relates to depreciation. © 2007 Pearson Custom Publishing Learning Objective 4:

22. 22 Revenue Recognition Under the accrual basis, revenue should be recognized when it is “earned” and you have earned revenue when you have a legally enforceable claim to receive something of value (usually cash) for the revenue. Under the accrual basis, revenue should be recognized when it is “earned” and you have earned revenue when you have a legally enforceable claim to receive something of value (usually cash) for the revenue. Cash may be received at the same time that the revenue is earned, after the revenue is earned, or before the revenue is earned. Cash may be received at the same time that the revenue is earned, after the revenue is earned, or before the revenue is earned. © 2007 Pearson Custom Publishing

23. 23 There are three questions that help determine when revenue should be recognized: There are three questions that help determine when revenue should be recognized: ¶ Has title to the “goods” been transferred to the customer? · Has an exchange of “goods” (or services) taken place? ¸ Is the earnings process virtually complete? (Has the business done all they need to do?) Revenue Recognition © 2007 Pearson Custom Publishing

24. 24 Discussion Questions You earn $3,000 from a house painting job. When should you recognize the revenue from this job if you use the: You earn $3,000 from a house painting job. When should you recognize the revenue from this job if you use the: cash basis of accounting? cash basis of accounting? accrual basis of accounting? accrual basis of accounting? © 2007 Pearson Custom Publishing

25. 25 Expense Recognition Under accrual accounting, an expense should be recognized when you receive the benefit from the expense. Under accrual accounting, an expense should be recognized when you receive the benefit from the expense. ¶ Cash might be paid at the time the expense is incurred, · Cash might be paid after incurring the expense, ¸ Cash might be paid before the expense is incurred. © 2007 Pearson Custom Publishing

26. 26 Think about the following three situations: Think about the following three situations: 1. You pay a one-year insurance premium. 1. You pay a one-year insurance premium. 2. You buy a scratch-off lottery ticket. 2. You buy a scratch-off lottery ticket. 3. You pay your utility bill ten days after it arrives in the mail. 3. You pay your utility bill ten days after it arrives in the mail. If you accounted for your life using the accrual basis, does the timing of the cash outflow coincide with the recognition of expense? (Before, same time, or after?) If you accounted for your life using the accrual basis, does the timing of the cash outflow coincide with the recognition of expense? (Before, same time, or after?) Discussion Questions © 2007 Pearson Custom Publishing

27. 27 Concept of Matching The accounting principle that supports the accrual approach to recording transactions is known as the matching principle. The accounting principle that supports the accrual approach to recording transactions is known as the matching principle. Revenues that are recognized for a specific time period should be matched with the expenses that were required (or used) in order to generate those revenues. Revenues that are recognized for a specific time period should be matched with the expenses that were required (or used) in order to generate those revenues. © 2007 Pearson Custom Publishing

28. 28 There may be a direct cause and effect between expenses and revenues. In this case, it is easy to properly apply the matching principle. There may be a direct cause and effect between expenses and revenues. In this case, it is easy to properly apply the matching principle. Concept of Matching © 2007 Pearson Custom Publishing

29. 29 Example of cause and effect: U.S. Mail Order Company received a phone order from a customer for a $100 item. U.S.M.O. pays a $5 shipping charge on the order. Example of cause and effect: U.S. Mail Order Company received a phone order from a customer for a $100 item. U.S.M.O. pays a $5 shipping charge on the order. The shipping expense is directly caused by the sale, and the expense should be recorded in the same time period as the sale, thus matching is achieved. The shipping expense is directly caused by the sale, and the expense should be recorded in the same time period as the sale, thus matching is achieved. Concept of Matching © 2007 Pearson Custom Publishing

30. 30 There might NOT be a direct cause and effect between expenses and revenues. Properly applying the matching principle is more difficult in this situation. There might NOT be a direct cause and effect between expenses and revenues. Properly applying the matching principle is more difficult in this situation. Solution #1: Allocation of expense to the time periods that are benefited. Solution #1: Allocation of expense to the time periods that are benefited. Example: two years’ rent paid in advance should be split between the two years. Example: two years’ rent paid in advance should be split between the two years. Concept of Matching © 2007 Pearson Custom Publishing

31. 31 If solution #1 is not reasonable, then use: If solution #1 is not reasonable, then use: Solution #2: Immediate recognition of expense. Solution #2: Immediate recognition of expense. Use this approach if: Use this approach if: a) there is no identifiable future benefit, or a) there is no identifiable future benefit, or b) if the future benefit cannot be reasonably measured. b) if the future benefit cannot be reasonably measured. Concept of Matching © 2007 Pearson Custom Publishing

32. 32 Example of Immediate Recognition Many companies spend huge amounts of money for “research and development.” There is little question that these expenditures lead to future benefits for the company. However, how do you estimate the dollar amounts of those benefits? Many companies spend huge amounts of money for “research and development.” There is little question that these expenditures lead to future benefits for the company. However, how do you estimate the dollar amounts of those benefits? Since we can’t reliably measure the future benefits, R&D costs are expensed immediately. Since we can’t reliably measure the future benefits, R&D costs are expensed immediately. © 2007 Pearson Custom Publishing

33. 33 Example of Cost Allocation One of the best examples of solution #1 (allocating the cost over time) is the depreciation of a long-term asset. Assume that your company buys a delivery truck that you plan to use for the next four years. One of the best examples of solution #1 (allocating the cost over time) is the depreciation of a long-term asset. Assume that your company buys a delivery truck that you plan to use for the next four years. The purchase cost of the truck should not be an expense when you buy it, but should be “spread out” over the next four years. The purchase cost of the truck should not be an expense when you buy it, but should be “spread out” over the next four years. © 2007 Pearson Custom Publishing

34. 34 Depreciation IS a procedure that allocates cost over more than one time period. Depreciation IS a procedure that allocates cost over more than one time period. Definition of depreciation: a systematic and rational allocation of the cost of a long-lived item from asset to expense. Definition of depreciation: a systematic and rational allocation of the cost of a long-lived item from asset to expense. Depreciation © 2007 Pearson Custom Publishing

35. 35 Depreciation IS NOT an attempt to measure the “fair market value” of an asset that is owned by a business. It IS NOT necessarily a way of determining how much of an asset’s value has been “used up.” Depreciation © 2007 Pearson Custom Publishing

36. 36 To calculate the annual depreciation for an asset, we need to make two estimates: To calculate the annual depreciation for an asset, we need to make two estimates: (1) the useful life of the asset (not necessarily the same as the total life of the asset), and (1) the useful life of the asset (not necessarily the same as the total life of the asset), and (2) the residual value of the asset (i.e., what it will be worth at the end of the useful life). (2) the residual value of the asset (i.e., what it will be worth at the end of the useful life). Depreciation © 2007 Pearson Custom Publishing

37. 37 The depreciable base is equal to the original cost minus the disposal value. The depreciable base is equal to the original cost minus the disposal value. Example: Your company buys a computer for $7,000. Estimated useful life is 4 years and estimated disposal value is $1,000. Example: Your company buys a computer for $7,000. Estimated useful life is 4 years and estimated disposal value is $1,000. The depreciable base is $6,000, and you would recognize depreciation expense of $1,500 per year ($6,000 / 4 years). The depreciable base is $6,000, and you would recognize depreciation expense of $1,500 per year ($6,000 / 4 years). Depreciation © 2007 Pearson Custom Publishing

38. 38 Depreciation Over the 4 years, most of the asset value is converted to expense. The cost is spread over the periods benefited. Over the 4 years, most of the asset value is converted to expense. The cost is spread over the periods benefited. © 2007 Pearson Custom Publishing

39. 39 Discussion Questions How would the cost of the computer system be treated if you were using the cash basis? How would the cost of the computer system be treated if you were using the cash basis? Look again at the depreciation schedule for the computer. Does the $4,000 book value at the end of 2010 represent what we could sell the system for at that time? Look again at the depreciation schedule for the computer. Does the $4,000 book value at the end of 2010 represent what we could sell the system for at that time? © 2007 Pearson Custom Publishing

40. 40 At the end of each accounting period, certain adjustments must be made prior to preparing the financial statements. At the end of each accounting period, certain adjustments must be made prior to preparing the financial statements. These adjustments are necessary to ensure that all items of revenue and expense have been properly recognized during the period. These adjustments are necessary to ensure that all items of revenue and expense have been properly recognized during the period. There are two basic types of adjustments: Accruals and Deferrals. There are two basic types of adjustments: Accruals and Deferrals. Adjustments © 2007 Pearson Custom Publishing

41. 41 Describe the difference between accruals and deferrals and provide examples of each. © 2007 Pearson Custom Publishing Learning Objective 5:

42. 42 An accrual adjustment would be necessary to recognize items that have not yet been recorded in the accounting records. An accrual adjustment would be necessary to recognize items that have not yet been recorded in the accounting records. An accrued revenue would be a revenue that has been earned but not yet recorded. An accrued revenue would be a revenue that has been earned but not yet recorded. An accrued expense would be an expense that has been incurred, but not yet recorded. An accrued expense would be an expense that has been incurred, but not yet recorded. Accruals © 2007 Pearson Custom Publishing

43. 43 Remember the house painting example. You didn’t get paid until the job was completed. However, if you were preparing an accrual basis income statement at the end of December, you would need to show $1,000 (1/3 of the total) of accrued painting revenue for the amount of work that you have completed so far. Remember the house painting example. You didn’t get paid until the job was completed. However, if you were preparing an accrual basis income statement at the end of December, you would need to show $1,000 (1/3 of the total) of accrued painting revenue for the amount of work that you have completed so far. Example of Accrued Revenue © 2007 Pearson Custom Publishing

44. 44 To start your house painting business, you took out a three-year small business loan at the local bank. You will pay back the principal and all of the interest at the end of three years. If the interest is $1,000 per year, you would have an accrued interest expense of $1,000 each year, even though you are not going to pay until the third year. To start your house painting business, you took out a three-year small business loan at the local bank. You will pay back the principal and all of the interest at the end of three years. If the interest is $1,000 per year, you would have an accrued interest expense of $1,000 each year, even though you are not going to pay until the third year. Example of Accrued Expense © 2007 Pearson Custom Publishing

45. 45 Deferrals A deferral is an item that has been recorded, but that should not be recognized as a revenue or expense until a later period. A deferral is an item that has been recorded, but that should not be recognized as a revenue or expense until a later period. A deferred revenue would occur when cash is received in advance, but not yet earned. A deferred revenue would occur when cash is received in advance, but not yet earned. A deferred expense would occur when cash has been paid in advance, but the expense has not been incurred (i.e., a prepayment). A deferred expense would occur when cash has been paid in advance, but the expense has not been incurred (i.e., a prepayment). © 2007 Pearson Custom Publishing

46. 46 Accrual Basis Financial Statements Financial statements that are prepared on the accrual basis will be the result of the proper application of all of the revenue and expense recognition rules, and the proper adjustments at the end of the period for all of the accruals and deferrals. Financial statements that are prepared on the accrual basis will be the result of the proper application of all of the revenue and expense recognition rules, and the proper adjustments at the end of the period for all of the accruals and deferrals. Let’s use the “My Proprietorship” example and make financials on the accrual basis. Let’s use the “My Proprietorship” example and make financials on the accrual basis. © 2007 Pearson Custom Publishing

47. 47 Accrual Basis Income Statement © 2007 Pearson Custom Publishing

48. 48 Discussion Questions Consider the following statement as it relates to the accrual basis of economic measurement: Consider the following statement as it relates to the accrual basis of economic measurement: “Net income is an opinion, cash is a fact.” “Net income is an opinion, cash is a fact.” What do you think it means? What do you think it means? © 2007 Pearson Custom Publishing

49. 49 Accrual Basis Statement of Capital © 2007 Pearson Custom Publishing

50. 50 Accrual Basis Balance Sheet © 2007 Pearson Custom Publishing

51. 51 Contrast the cash basis and accrual basis of economic measurement, describing the relative strengths and weaknesses of each. © 2007 Pearson Custom Publishing Learning Objective 6:

52. 52 Comparing the Two Bases The main strength of the accrual basis is in the concept of the matching principle, where revenues and expenses are reported in the same time period. This gives a better picture of past performance as a means to predict future performance. The main strength of the accrual basis is in the concept of the matching principle, where revenues and expenses are reported in the same time period. This gives a better picture of past performance as a means to predict future performance. © 2007 Pearson Custom Publishing

53. 53 Comparing the Two Bases The main strength of the cash basis is the increase in objectivity. It is easy to determine in which time period a cash flow took place. The main strength of the cash basis is the increase in objectivity. It is easy to determine in which time period a cash flow took place. © 2007 Pearson Custom Publishing

54. 54 The main weakness of the accrual basis is that the focus is shifted away from cash (remember “cash is the ball”). For example, you might have a positive net income but a negative cash flow. The main weakness of the accrual basis is that the focus is shifted away from cash (remember “cash is the ball”). For example, you might have a positive net income but a negative cash flow. Comparing the Two Bases Net Income Cash Flows © 2007 Pearson Custom Publishing

55. 55 The main weakness of the cash basis is the lack of matching between revenues and expenses. The main weakness of the cash basis is the lack of matching between revenues and expenses. So which is better? The answer to that question may be in the eye of the beholder, but Generally Accepted Accounting Principles are based on the accrual accounting method. So which is better? The answer to that question may be in the eye of the beholder, but Generally Accepted Accounting Principles are based on the accrual accounting method. Comparing the Two Bases © 2007 Pearson Custom Publishing

56. 56 End of Chapter 6 © 2007 Pearson Custom Publishing