University of Evansville - Accounting 210 Chapter 4

1. 8/e
Income
Measurement and
Accrual
4 Accounting

2. Recognition
The process of formally recording or incorporating
an item into the financial statements of an entity as
an asset, a liability, a revenue, an expense, and the
like.
Sales

3. Measurement
Historical Cost – simplest and most verifiable
Current Value – the estimated value of the asset
Reliability vs. Relevance
Because of its objective
nature, historical cost is the
attribute used to measure many
non-current assets.

4. 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

5. Cash basis Accrual basis
statement statement
Statement of Income
Cash Flows Statement
Cash flows from Net income:
operating activities: $ 7,000
$(4,000)
What accounts for
the difference?

6. Revenue Recognition Principle
Revenue is recognized when realized or
realizable and earned—usually at time of sale
Exceptions:
 Long-term contracts
 Franchises
 Commodities
 Installment sales
 Rent and interest
LO3

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

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

9. Types of Adjustments
Deferred Accrued
expense RECOGNIZE liability
REVENUE OR
EXPENSES
BEFORE OR AFTER
CASH IS
EXCHANGED
Accrued Deferred
asset revenue
LO5

10. 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

11. 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

12. Deferred Expense Example
Prepay $2,400 for insurance for one year on September 1

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

14. Deferred Expense Example
Purchase new store fixtures on January 1 for $5,000; estimated useful
life is 5 years 60 months); estimated salvage value is $500
Purchase of Store fixtures:

15. Deferred Expense Example
Monthly adjustment:
($5,000 – $500) 1/60 = $75 per month for 60 months)

16. 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

17. Deferred Revenue Example
Received $2,400 for an insurance policy in advance:

18. Deferred Revenue Example
Monthly adjustment:
($2,400 annual 1/12 = $200 per month for 12 months)

19. 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

20. Accrued Liability Example
Biweekly wages are $280,000

21. Accrued Liability Example
At end of month, between pay periods:

22. Accrued Liability Example
Next payday:

23. Accrued Liability Example
On March 1, assume a 9%, 90-day, $20,000 loan is taken

24. Accrued Liability Example
Monthly adjustment:
($20,000 principal 9% 1/12 = $150/month )

25. Accrued Liability Example
Payment of principal and interest on May 30

26. 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

27. Accrued Asset Example
Rent payment of $2,500 due within first 10 days of month

28. Accrued Asset Example
Upon receipt of cash:

29. 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

30. Ethics and
Accrual Accounting
 Accountants must remember their
primary responsibility is preparing
financial statements is to portray the
affairs of the company accurately to
various outside users.
 Bankers, stockholders, and others
rely on the accountant to serve their
best interests.

31. Steps in the Accounting Cycle
1. Collect and
7. Close the analyze info
2. Journalize
accounts transactions
6. Record and
post adjusting 3. Post
entries transactions to
general ledger
5. Prepare
financial 4. Prepare
statements work sheet
LO6

32. The Use of a Worksheet
 Used at the end of the period to gather
the information needed to prepare
financial statements without actually
recording and posting entries
 The worksheet is not a financial statement
 Useful device to organize the information
needed to prepare the financial statements
at the end of the period

33. 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

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