Chapter 4

1. Chapter 4 Income Measurement and Accrual Accounting Financial Accounting 4e by Porter and Norton

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

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

4. Income Statement Net income $ 7,000 Accrual basis statement Cash basis statement 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- over life of project • Franchises- upon substantial performance • Commodities - when readily convertible • Installment Sales- when cash is collected • Rent and Interest- continuously when earned

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

7. Simultaneously upon their acquisition Indirectly over period they provide benefits Matching Principle Match Expenses with Associated Revenues Directly e.g. Buildings e.g. Inventory e.g. Utilities

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

9. Deferred Expense - Cash paid before expense is incurred • Examples: • Prepaid rent & insurance • Office supplies • Plant & equipment • Costs are initially recorded as assets and allocated to expense in future periods

10. Deferred Expense Example #1 – Prepay rent on office space for one year on Sept. 1 Initial J/E:Dr.Cr. Prepaid Rent 2,400 Cash 2,400 Monthly adjusting J/E: Rent Expense 200 Prepaid Rent 200 ($2,400 annual x 1/12 = $200 per mo. for 12 mos.)

11. Deferred Expense Example #2 -Purchase delivery truck on January 1 for $21,000. Estimated useful life is 5 years (60 months); estimated salvage value is $3,000. Initial J/E:Dr.Cr. Delivery Truck 21,000 Cash 21,000 Monthly adjusting J/E: Depreciation Expense 300 Accumulated Depreciation 300 ($21,000 - $3,000) x 1/60 = $300 per mo. for 60 mos.)

12. Deferred Revenue -Cash received before revenue is earned • Examples: • Rent 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 -Receive $2,400 for twelve months rent in advance Initial J/E:Dr.Cr. Cash 2,400 Rent Collected in Advance 2,400 Monthly adjusting J/E: Rent Collected in Advance 200 Rent Revenue 200 ( $2,400 annual x 1/12 = $200 per mo. for 12 mos.)

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 -Pay biweekly wages of $28,000 At end of month, between pay periods:Dr.Cr. Wages Expense 4,000 Wages Payable 4,000 Next payday: Wages Payable 4,000 Wages Expense 24,000 Cash 28,000

16. Accrued Liability Example #2 - Borrow $20,000 for three months. Principal plus 9% interest due at end of loan period. Initial J/E:Dr.Cr. Cash 20,000 Note Payable 20,000 Monthly adjusting J/E: Interest Expense 150 Interest Payable 150( $20,000 principal x 9% x 3/12 = $450 for 3 months or $450/3 = $150 per month)

17. Revenue 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

18. Accrued Asset Example -Rent payment due within first 10 days of month First day of the month:Dr.Cr. Rent Receivable 2,500 Rent Revenue 2,500 Upon receipt of cash: Cash 2,500 Rent Receivable 2,500

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

20. Revenues Expenses Normal balance Normal balance Close to income summary Close to income summary $ XX $ XX Temporary Accounts $ XX $ XX Dividends Zero out temporary accounts to start accumulation of next period’s results. Normal balance Close to retained earnings $ XX $ XX

21. Income Summary $xx from expense accounts $xx from revenue accounts (net loss) or net income closed to retained earnings Closing Entries

22. Appendix Accounting Tools: Work Sheets

23. Unadjusted Trial Balance columns Begin by filling in the trial balance accounts and amounts

24. Adjusting Entry columns Make adjustments. Formal journal entries are prepared later.

25. Adjusted Trial Balance columns Add or subtract adjustments for adjusted acct. balances

26. Income Statement columns Extend revenue and expense account balances to the income statement

27. Balance Sheet columns Extend asset, liability and equity accounts to the balance sheet

28. End of Chapter 4