1. Chapter 4 Income Measurement and Accrual Accounting
Using Financial Accounting Information:
The Alternative to Debits and Credits, 6/e by
Gary A. Porter and Curtis L. Norton
Copyright © 2009 South-Western, a part of Cengage Learning.

2. 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

3. 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

4. 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?

5. 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

6. 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

7. 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

8. Types of Adjusting Entries
Deferred
expense
Accrued
liability
RECOGNIZE REVENUE OR EXPENSES
BEFORE OR AFTER CASH IS EXCHANGED
Accrued
asset
Deferred
revenue
LO5

9. 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

10. Deferred Expense Example #1
Prepay $2,400 for insurance for one year on September 1
Initial journal entry:
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ Revenues − Expenses
Equity
Prepaid
Insurance 2400
Cash (2400)
Monthly adjusting journal entry:
Prepaid Insurance (200) Insurance Expense (200) ($2,400 annual × 1/12 = $200 per month for 12 months)

11. Deferred Expense Example #2
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 #2
Purchase of Store fixtures:
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity
Store fixtures 5,000
Cash (5,000)
Monthly adjusting journal entry:
Accumulated Depreciation Expense Depreciation (75) (75)
($5,000 – $500) × 1/60 = $75 per month for 60 months)

12. 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

13. Deferred Revenue Example
Received $2,400 for an insurance policy in advance:
Initial journal entry:
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity
Cash 2,400
Insurance Collected
in Advance 2,400
Monthly adjusting journal entry:
Insurance Collected in Advance (200) Rent Revenue 200
($2,400 annual × 1/12 = $200 per month for 12 months)

14. 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

15. Accrued Liability Example #1
Biweekly wages are $280,000
At end of month, between pay periods:
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity
Wages Payable Wages Expense , (40,000)
Next payday:
Cash Wages Payable Wages Expense
(280,000) (40,000) (240,000)

16. Accrued Liability Example #2
On March 1, assume a 9%, 90-day, $20,000 loan is taken
Initial journal entry:
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ Revenues -- Expenses Equity
Cash Note Payable
20, ,000
Monthly adjusting journal entry:
Interest Payable Interest Expense (150)
($20,000 principal × 9% × 1/12 = $150/month )

17. Accrued Liability Example #2
Payment of note and interest:
Balance Sheet Income Statement
Assets = Liabilities + Stockholders’ + Revenues − Expenses Equity
Cash (20450) Notes Payable (20000) Interest Expense (150)
Interest Payable (300)

18. 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

19. Accrued Asset Example
Rent payment of $2,500 due within first 10 days of month
First day 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)

20. 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

21. The Closing Process
Real Accounts: Balance Sheet accounts are permanent
accounts and are never closed
Balances are carried over from one period to the next
Nominal Accounts: These are temporary accounts
These accounts are closed at the end of the period and
these balances are not carried over from one period to
another
Revenues, Expenses and
Dividends
Zero out
nominal accounts
to start accumulation
of next period’s
results

22. Closing Entries Closing Entries serve two purposes:
To return the balances in all temporary
or nominal accounts to zero to start
the next accounting period
To transfer the net income (or net loss)
and the dividends of the period to the
Retained Earnings account

23. Interim Statements or at other intervals less than a year
Financial statements prepared monthly, quarterly,
or at other intervals less than a year
Used for internal purposes

24. End of Chapter 4