PorterNorton Income Measurement and Accrual Accounting

1
Chapter 4
Income Measurement and Accrual Accounting
2
Key Concepts Objectives

• GAAP Principles Revenue Recognition, Measurement
  Matching
• Cash Basis vs. Accrual Basis Accounting
• Accrual requires Period-end Adjustments
• Accrued Revenues Accrued Expenses
• Deferred Revenues Deferred Expenses
• Accounting Cycle closing Temporary Accounts

3
Recognition and Measurement
Recognition Formally recording economic
events in the accounting records
4
Revenue Recognition Principle

• Recognize revenue when realized earned
• Goods are sold, or
• Services are provided

5
Matching Principle
Concept Match efforts (expenses) with rewards
(revenues) so as to get a complete picture of
operating performance. IT TAKES MONEY TO MAKE
MONEY.
6

Accrual basis statement

• Cash basis
• statement

Statement of Cash Flows
Cash flows from operating activities
4,000 (Cash Net Income)
7
Cash vs. Accrual Basis

• Cash basis Revenues are recorded when cash is
  received and Expenses are recorded when cash is
  paid.

Accrual basis Revenues are recognized when
earned expenses are recognized when incurred (or
assets used up).
Revenues Expenses are recorded regardless of
when cash is received or paid.
8
Comparison Cash vs. Accrual Basis
9
Expense Recognition(Expenses are created in many
different ways)Point Most Assets eventually
become Expenses
Balance Sheet
Income Statement
ASSETS Inventory Supplies (Prepaids) Plant
Equipment Intangibles
EXPENSES
when sold
Cost of Goods Sold
Supplies Expense Insurance Expense
as used up
over periods they provide benefits
Depreciation Exp. Patent Expense
10
Expense Recognition(Expenses are created in many
different ways)Point Cash Basis Expenses are
often Accrual Basis Expenses
ACCRUAL BASIS EXPENSES
Examples reflect payment in same period when
acruall. expense USED
CASH BASIS EXPENSES Pay Rent (March 1,
2002) Pay Wages (May 15, 2002) Pay Utility
bill (June 10, 2002)
Rent Expense (March 2002)
When paid
Wage Expense (May 2002)
When paid
When USED
Utilities Expense (May 2002)
11
Financial Statements at end of period must be on
a Full (100) Accrual Basis of Accounting

• It is impractical during the period to be fully
  Accrual Basis.
• The cost of constantly preparing Accrual Basis
  information (e.g., calculating depreciation
  daily!) outweighs its benefits.
• Companies can manage during period without having
  full Accrual Basis information
• But Accrual Basis is most important for external
  financial statement users ? Besides, it is GAAP!

12
Overview of Adjusting Entries

• So, at the end of the period, a company must
  prepare ADJUSTING ENTRIES to bring accounts to
  100 Accrual Basis accounting!
• Internal transaction
• Adjusting journal entry (AJE) never involves cash
  (Why?)
• Involves at least one Balance Sheet account and
  one Income Statement account

13
Four Types of Adjustments are needed for full
Accrual Basis of Accounting for F/S
Deferrals mean cash is received (or paid) BEFORE
revenue (or expense) is recognized under Accrual
Basis accounting.
14
Four Types of Adjustments are needed for full
Accrual Basis of Accounting for F/S
Accruals mean cash is received (or paid) AFTER
revenue (or expense) is recognized under Accrual
Basis accounting.
15
Only Four Types of Adjustments(always involve
both B/S and I/S accounts)
Deferral Cash first Accrual Cash later

16
Only Four Types of Adjustments(always involve
both B/S and I/S accounts)
Deferral Cash first Accrual Cash later

17
Only Four Types of Adjustments(always involve
both B/S and I/S accounts)
Deferral Cash first Accrual Cash later

18
Only Four Types of Adjustments(always involve
both B/S and I/S accounts)
Deferral Cash first Accrual Cash later

19
Only Four Types of Adjustments(always involve
both B/S and I/S accounts)
Deferral Cash first Accrual Cash later

20
The Balance Sheet Equation can now be Expanded!
---------Balance Sheet--------------
---Income Statement--- Assets Liabilities
Owners Equity Revenue - Expenses
Revenues Expenses are still part of Owners
Equity, but we just show it separately to also
have information on the Income Statement.
Dont forget Revenues increase OE and Expenses
decrease OE.
21
1 Accrued Revenue (Asset) - Revenue earned
before Cash is received

• Examples
• Accounts Receivable
• Interest Receivable
• Record Revenue (and corresponding receivable) in
  period earned and
• Receive Cash payment (and pay-off receivable) in
  a future period

22
Accrued Revenue Example - Sell 1,000
merchandise on account on January 31,
2002Payment is due in 28 days (2/28/02)
All accruals have no original entry. So we just
need to record the adjusting entry on January
31st.
What two accounts are needed to update to full
Accrual Basis for the merchandise sold?
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to get us to
these amounts!
A Accounts Receivable
R Sales Revenue
23
Accrued Revenue Example - Sell 1,000
merchandise on account on January 31,
2002Payment is due in 28 days (2/28/02)
Now lets record the effect of this Adjusting
entry on the Balance Sheet Equation to get us to
these amounts!
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Sales Revenue 1,000
Accounts Receivable 1,000
1/31/02
A Accounts Receivable
R Sales Revenue
24
Accrued Revenue Example - Sell 1,000
merchandise on account on January 31,
2002Payment is due in 28 days (2/28/02)
Now lets record the effect of this transaction
when it is collected on February 28th
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Cash 1,000
2/28/02
A/R (1,000)
R Sales
A Cash
A A/R
1,000
1,000
Jan. Rev
0
25
2 Deferred Revenue - Cash received before
Revenue is earned

• Examples
• Rent collected at beginning of month
• Subscriptions collected in advance
• Cash receipts are initially recorded as
  Liabilities (unearned revenue or refundable
  receipts), and
• Recorded as Revenues in future periods when
  earned as goods delivered or service is provided.

26
Deferred Revenue Example Receive 1,200 for
three months rent in advance on 1/1/02
All deferrals have an original (non-adjusting
entry) entry. So what is this original entry on
Jan. 1st?
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Why is this a LIABILITY?
1/1/02
Theoretically Revenue should be updated every day
to completely follow the full Accrual Basis.
Practically, Revenue is updated at the end of
the period to its proper balance by an adjusting
entry.
27
Deferred Revenue Example Receive 1,200 for
three months rent in advance on 1/1/02
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Unearned Revenue 1,200
Cash 1,200
Now it is the end of January and time for MONTHLY
adjusting entries to get F/S on full Accrual Basis
What 2 accounts are needed to reflect the proper
balance of Revenue?
28
Deferred Revenue Example Receive 1,200 for
three months rent in advance on 1/1/02
Lets calculate what earned Rent Revenue should
be
Rent Revenue 1,200 /3 months 400 per month
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
the rent earned.
R RENT REVENUE
L UNEARNED REV
1,200 1/1/02
Jan. 02 I/S
400
Rev Earned?
Rev Earned?
400
1/31/02 B/S
800
Remaining Liability?
29
Deferred Revenue Example Receive 1,200 for
three months rent in advance on 1/1/02
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
the rent earned.
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
1/31/01
30
3 Deferred Expense - Cash paid before Asset
(Deferred Expense) is used

• Examples
• Prepaid rent insurance
• Office supplies
• Plant equipment
• Costs are initially recorded (deferred) as Assets
  because they provide future economic benefit
  later they are
• Allocated to Expense in future periods, as they
  are used up to help generate revenues.

31
Deferred Expense Example 1 - Purchase 1-year
insurance policy for 3,600 on 3/1/02
All deferrals have an original (non-adjusting
entry) entry. So what is this original entry?
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
This is a typical operating activity and
represents an exchange of one asset for another.
Theoretically, Insurance Expense (used up asset)
should be updated every day to exactly follow
Accrual Basis. Practically, its only updated
(to its proper balance) at the end of the period
through adjusting entry.
32
Deferred Expense Example 1 - Purchase 1-year
insurance policy for 3,600 on 3/1/02
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Prepaid Insurance 3,600 Cash (3,600)
Now it is the end of March and time for recording
an adjusting entry to get the F/S to the full
Accrual Basis
3/1/02
What 2 accounts are needed to reflect the proper
balances of Insurance?
33
Deferred Expense Example 1 - Purchase 1-year
insurance policy for 3,600 on 3/1/02
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Lets calculate what Insurance Expense should be
Formula Insurance Expense Yearly Premium / 12
Insurance Expense 3,600 / 12 300
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
this adjustment.
A Prepaid Insurance
E Insurance Expense
Future benefit at March 1st
3/1/02 3,600
Used Up?
300
Used up?
300
On March I/S
What is future benefit at March 31st?
3/31/02 3,300
On 3/31/02 B/S
34
Deferred Expense Example 1 - Purchase 1-year
insurance policy for 3,600 on 3/1/02
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
this adjustment.
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
3/31/02
Dont forget that EXPENSES REDUCE OWNERS EQUITY
A Prepaid Insurance
E Insurance Expense
3/1/02 3,600
300
300
On March I/S
Future benefit at March 31st
3/31/02 3,300
On B/S
35
How is Property, Plant Equipment Information
shown on the Balance Sheet?
Represents ORIGINAL HISTORICAL COST
A Refresher!
Partial Balance Sheet
Property, Plant Equipment 10,000
Amount already expensed over the entire life of
the assets based on the original cost
Less Accumulated Depreciation 4,000
Net PPE (Book Value) 6,000
Amount of assets original historical cost that
reflects estimated future benefit
BOOK VALUE IS NOT MARKET VALUE!
36
Deferred Expense Example 2 - Purchase computer
on July 1 for 5,000. Estimated useful life is
3 years (36 months) estimated salvage value is
500.
All deferrals have an original (non-adjusting
entry) entry. So what is this original entry?
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
This is a typical investing activity and an
exchange of one asset for another longer term
asset.
7/1/02
The expense is deferred (recorded as an Asset)
until is is used up.
Theoretically, Computer Depreciation Expense
should be updated every day to follow full
Accrual Basis. Practically, it is only updated to
its proper balance at the end of the period
through an adjusting entry.
37
Deferred Expense Example 2 - Purchase computer
on July 1 for 5,000. Estimated useful life is
3 years (36 months) estimated salvage value is
500.
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Now it is the end of the month and time for
MONTHLY adjusting entries to get F/S on full
Accrual Basis
Computer Equipment 5,000 Cash (5,000)
7/1/02
What 2 accounts are needed to reflect the proper
balances of the Computer used up?
A Computer Equipt.
7/1/02 5,000
38
Deferred Expense Example 2 - Purchase computer
on July 1 for 5,000. Estimated useful life is 3
yrs (36 months) estimated salvage value is 500.
Lets calculate what Depreciation Expense should
be
Depreciation Expense (Cost - Salvage Value) /
Useful Life
Depreciation Expense 5,000 - 500 / 36
months 125
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
this calculation.
Beg. Balance
00
Used up this period?
Used up this period?
125
125
On July I/S
7/31/02 B/S
125
Total Over Life?
39
Deferred Expense Example 2 - Purchase computer
on July 1 for 5,000. Estimated useful life is 3
yrs (36 months) estimated salvage value is 500.
Now lets record the effect of this Adjusting
entry on the Balance Sheet Equation
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
Depreciation Expense (125)
Accumulated Depreciation (125)
7/31/02
A Contra Asset (CA) account to show more B/S
information (more detailed).
00
125
125
July 2002 I/S
7/31/02 125
40
How is Property, Plant Equipment Information
shown on the Balance Sheet?
What is happening to Book Value over time? Why?
Partial Balance Sheet (at 7/31/02)
As Assets are used up over time, the Book Value
DECREASES!
Property, Plant Equipment 5,000
Less Accumulated Depreciation (125)
Net PPE (Book Value) 4,875
500 (the estimated salvage value)
41
4 Accrued Expense - Expense incurred (benefit
is received) before Cash is paid

• Examples
• Payroll expense
• Utilities expense
• Interest expense
• Record Expense (and corresponding Liability) in
  the period incurred (when benefit is received)
  and then
• Record Cash in a future period, when paid.
• No cash flow upon recording, only when paid

Does this remind you of anyone you know?
42
Accrued Expense Example 1- 350 telephone bill
is received on January 31st but due next month
All accruals have no original entry . So just
need to record the adjusting entry?
What two accounts are needed to update the F/S to
reflect the full Accrual Basis for the telephone
bill?
Now lets record the effect of this Adjusting
entry on the Balance Sheet Equation to get us to
these amounts!
E Telephone Expense
L Utilities Payable
NOTE OK, but most companies would use Accounts
Payable (A/P)
43
Accrued Expense Example 1- 350 telephone bill
is received on January 31st but due next month
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
full Accrual Basis.
---------Balance Sheet-------------- ---Income
Statement--- Assets
Liab. OE Rev. - Expenses
1/31/02
E Telephone Expense
L Utilities Payable
44
Accrued Expense Example 1- 350 telephone bill
is received on January 31st but due next month
Now lets record the effect of this Telephone
bill when it is paid on February 15th.
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
2/15/02
E Telephone Exp.
L Utilities Payable
A Cash
350
Jan. Exp
350
350
350
0
0
45
Accrued Expense Example 2 -Borrow 6,000 for
six months on January 1st. Principal plus 10
annual interest is due at end of loan period.
What is the January 1st entry to record the CASH
loan?
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
1/1/02
This is a typical financing activity generally
used to short-term address cash flow needs.
The next activity is to accrue Interest Expense
at end of January.
46
Accrued Expense Example 2 -Borrow 6,000 for
six months on January 1st. Principal plus 10
annual interest is due at end of loan period.
On January 31st we need to recognize interest
expense. Accruals have no original entry .
What two accounts are needed to update F/S to the
full Accrual Basis for the interest? (Monthly
adjusting entry)
Now lets calculate the amount of Interest
Expense owed at the end of January but not paid
until maturity (June 30th).
47
Accrued Expense Example 2 -Borrow 6,000 for
six months on January 1st. Principal plus 10
annual interest is due at end of loan period.
Now lets figure out the amount of Interest
Expense owed but not paid for this period.
Standard interest formula
Interest Expense Principal x Interest rate x
Time (adj.)
6,000
10
1/12
x
x
50
Jan 50
Feb 50
March 50
April 50
May 50
June 50
Same adjustment is made every month
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
these accruals!
48
Accrued Expense Example 2 -Borrow 6,000 for
six months on January 1st. Principal plus 10
annual interest is due at end of loan period.
Now lets record the effect of this adjusting
entry on the Balance Sheet Equation to reflect
the 50 accrual for January interest.
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
1/31/02
49
Accrued Expense Example 2 - Repay 6,000
principal plus 10 annual interest at end of loan
period (June 30, 2002).
Jan 50
Feb 50
March 50
April 50
May 50
June 50
Interest Expense
Interest Payable
On I/S Jan
Jan. increase
50
50
300
6/30/02 Balance
50
Accrued Expense Example 2 - Repay principal of
6,000 plus accrued interest (at 10 annual) on
maturity date (6/30/02).
---------Balance Sheet-------------- ---Income
Statement--- Assets Liab.
OE Rev. - Expenses
6/30/02
A Cash
L Interest Payable
L Notes Payable
Balances before pymt.
300
6,000
51
Steps in the Accounting Cycle
1. Collect and analyze info
7. Close accounts Start next period
2. Journalize Transactions (G/J)
3. Post transactions to accounts in G/L
6. Prepare Financial Statements
4. Prepare Worksheet (Trial Balance)
5. Record post adjustments
52
Closing the Accounts

• Balance Sheet accounts (permanent or real
  accounts) are carried forward to the next period
  e.g., Cash 12/31/X1 Cash 1/1/X2

53
Closing the Accounts

• Revenue, Expense and Dividend accounts (temporary
  or nominal accounts) are closed at the end of the
  period are not carried over
• Closing means zeroing out this years balances

1/1/X2 Beginning Balances (R, E,
Div.) - 0 -
12/31/X1 Ending Balances (of R, E Div.) are
closed to Retained Earnings

54
Summary Key Concepts Objectives

• GAAP Principles Revenue Recognition, Measurement
  Matching
• Cash Basis vs. Accrual Basis Accounting
• Accrual requires Period-end Adjustments
• Accrued Revenues Accrued Expenses
• Deferred Revenues Deferred Expenses
• Accounting Cycle closing Temporary Accounts