Chapter 4, Income measurement and Accrual Accounting PDF

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Summary of chapter 4, used the course book as source....

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Chapter 4, Income measurement and Accrual Accounting Recognition and Measurement - form of communication Recognition = The process of formally recording an item into the financial statement of an entity as an asset, a liability, a revenue, an expense or the like. Assets, liabilities, revenues and expenses depicted in the financial statements are representations. Measurement = Accountants depict a financial statement item in both words, and numbers; effects of economic events on an entity must be quantified by the accountant - (measure the event’s financial effects on the company). Two choices must be made: 1. decide on the attribute to be measured 2. a unit of measure must be chosen 1. Attribute: What attribute (characteristic) of a bought property should be used to measure and thus recognize it as an asset on the balance sheet? Simplest approach: historical cost, because it is an amount that can be agreed upon. Historical cost: the amount paid for an asset and used as a basis for recognizing it on the balance sheet and carrying it on later balance sheets. Alternative approach: Current value: the amount of cash or ira equivalent that could be received by selling an asset currently (Estimated selling price). 2. Unit of Measure: In money term, use of the dollar as a unit of measure for financial transactions is widely accepted (despite instability - inflation) Economic events are thus recognized with words and numbers and measured with attribute (historical cost) and the dollar as unit of measure.

The Accrual Basis of Accounting The cash and accrual bases of accounting differ with respect to the timing of the recognition of revenues and expenses. Cash basis = A system of accounting in which revenues are recognized when cash is received and expenses are recognized when cash is paid. Accrual basis = A system of Accounting in which revenues are recognized when a performance obligation is satisfied and expenses are recognized when incurred. CASH BASIS

ACCRUAL BASIS

REVENUE RECOGNIZED

When received

When performance obligation is satisfied

EXPENSE RECOGNIZED

When paid

When Incurred

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The income statement reflects revenues and expenses on an ACCRUAL BASIS

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regardless of when cash is received or paid The statements of cash flows tells the reader about ACTUAL CASH INFLOWS and OUTFLOWS during a period of time.

The Revenue Recognition Principle Revenues = inflows of assets or settlements of liabilities from delivering or producing goods, rendering services, or conducting other activities that constitute the entity’s major or central operations. Revenues Recognition Principle; revenues are recognized when a performance obligation is satisfied. Expense Recognition and the Matching Principle Anytime a cost is incurred, an asset is acquired. Asset = future economic benefit. Asset cease being an asset and becomes an expense when the economic benefits from having incurred the cost have expired. Asset = unexpired cost, Expense = expired cost The Expense recognition principle requires that expenses be recognized in different ways, depending on the nature of the cost. Ideal Approach: recognize expenses and match them with revenues. Matching Principle = The association of revenue of a period of time with all of the costs necessary to generate that revenue. For certain types of expenses, a direct form of matching is possible for others it is necessary to associate costs with a particular period. ● ●

Direct match: COGS with revenue or commission of a salesperson and revenue. Indirect; used to recognize benefits associated with certain types of costs (long-term assets) A building might be useful to a company for 30 years. Depreciation = process of allocating the cost of a tangible long-term asset to its useful life. (recognized as depreciation expense) Expenses = outflows of assets or incurrence of liabilities from delivering goods, rendering services or carrying out other activities. They come about in two ways: 1. from the use of an asset, 2. from the recognition of a liability. Module 2 - Adjusting Entries Adjusting entries = journal entries made at the end of a period by a company using the accrual basis of accounting. Types of adjusting Entries Cash Paid before Expense is Incurred (Deferred Expense) Insurance policies, rent, office supplies, property and equipment Assets = unexpired costs. As costs expire and the benefits are used up, assets must be written off and replaced with an expense. Two estimates must be made in depreciating fixtures 1. estimated useful life of asset

2. estimated scrap value of the fixtures Straight-line method: The assignment of an equal amount of depreciation to each period. Adjustment to recognize depreciation is the same as the adjustment to write off Prepaid Insurance. Asset account is reduced and an expense is recognized. Contra Account: An account with a balance that is opposite that of a related account. Accumulated Depreciation = used to record the decrease in a long-term asset for depreciation, carries a credit balance. Increase in Accumulated Depreciation - recorded with a credit; because we want to decrease the amount of assets and assets are decreased with a credit. If asset account were reduced each time depreciation was recorded, its original cost would not be readily determinable from the accounting records - that’s why contra account. Cash received before Revenue is Recognized (Deferred Revenue) One company’s assets is another company’s liabilities. If Insurance (in advance) is paid to a company, the account Insurance Collected in Advance is a Liability, because the Insurance Company is obliged to provide protection to the company it sold the insurance to for the months in advance that the company paid for (12 months). With passage of time, the liability is satisfied. Adjusting entry at the end of each month accomplishes two purposes, it recognizes: 1. the reduction reduction in liability (debit) 2. the revenue each month (credit) Same applies to gift cards that have been bought but not yet redeemed, the company will recognize the purchase of the gift-card as liability,cash increases and liability increases. When giftcard is used, revenue is recognized and liability is decreased. Expense Incurred Before Cash Is Paid (Accrued Liability) Cash is paid after an expense is actually incurred, rather than before. Normal operating costs such as payroll, various types of taxes, utilities and such fit this situation. Accrued liabilities: salaries, wages. Wages must be recognized as liabilities if the company owes wages to employees, the company must recognize an expense for the wages earned by employees. (wage expense -debit/wages payable - credit) Once wage has been paid: (wages payable debit/wage expense - debit) Another expense incurred before payment of cash: interest on short-term loans, which is repaid in many cases with the amount of the loan called the principal.

Revenue Recognized Before Cash Is Received (Accrued Asset) Remt. membership revenue and whenever else a company records revenue before cash is received, some type of receivable is increased and revenue is also increased Accruals and Deferrals

Deferral = Cash has been paid or received but expense, or revenue has not yet been recognized. Deferred expense = an asset resulting from the payment of cash before the incurrence of the expense (prepaid expense). Deferred expense = Future economic benefit = Asset ..such as prepaid insurance or office supplies or long-term assets (depreciation) Adjusting entry is made periodically to record portion of deferred expense that has expired. Deferred revenue = a liability resulting from the receipt of cash before the recognition of revenue. Deferred revenue = obligation = Liability..such as rent collected in advance. Periodic adjusting entry recognized the portion of deferred revenue that is recognized in that period. OPPOSITE: Accrual = Csh has not yet been paid or received but expense incurred or revenue recognized. Accrued Liability = recognized at the end of a period in cases in which an expense has been incurred but cash has not yet been paid. Wages payable and interest payable are examples. Accrued asset = recorded when revenue has been recognized but cash has not yet been collected. Rent receivable is an example. Summary of Adjusting entries 1. adjusting entry = internal transaction, does not involve another entity 2. Because its internal; it does not involve any increase/decrease in cash 3. At least one balance sheet account and one income statement account are involved in an adjusting entry. It is in the nature of the adjustment process that an asset or a liability account is adjusted with a corresponding change in a revenue/expense account.

TYPE

SITUATION

EXAMPLES

ENTRY DURING PERIOD

ENTRY AT THE END OF THE PERIOD

Deferred Expense

Cash is paid before Expense is incurred

Insurance policy, supplies, rent, buildings, equipment

Asset Cash

Expense Asset

Deferred Revenue

Cash is received before revenue is recognized

Deposit, Rent,Gift cards,

Cash Liability

Liability Revenue

Accrued Liability

Expense is incurred before cash is paid

salaries, wages, interest, taxes, rent

No entry

Expense Liability

Accrued Asset

Revenue recognized before cash is received

Rent(when customer has time until next month to pay) Interest

No entry

Asset Revenue

Trial balance = an important tool to use in preparing adjusting entries. Trial Balance (p.166), then adjusting entries (p.166-169) and then updated version of trial balance. (p.170) Module 3 - Accounting Cycle and Closing Entries A series of steps with one objective that always stays the same: collect necessary information to prepare a set of financial statements. Accounting cycle(steps repeated each period) = a series of steps performed each period and culminating with the preparation of a set of financial statements. (Steps 1 and 2 take place continuously.) Step 1: Collect and Analyze information from source documents(Transaction Analysis). Most challenging step of all; requires ability to think logically about an event and its effect on the financial position of the entity. Step 2: Journalize transactions (Step 3 takes place either periodically or immediately in computerized systems.) Step 3: Post transactions to accounts in the ledger.

(Steps 4-7 are only done at the end of each period) Step 4: Prepare work sheet; a device used at the end of the period to gather the information

needed to prepare financial statements (without actually recording and posting adjusting entries). Step 4 is optional and not a financial statement, if skipped then step 6 comes before step 5. Step 5: Prepare financial statements Step 6: Record and post adjusting entries Step 7: Close the accounts

The Closing Process Real accounts: The name given to balance sheet accounts because they are permanent and are not closed at the end of the period. Nominal Accounts: The name given to revenue, expense and dividend Accounts because they are temporary and are closed at the end of each period. Closing entries: Journal entries done at the end of each period to return the balance in nominal accounts to zero and transfer the net income/loss and the dividends to retained earnings. ● An account with a debit balance is closed by crediting the account for the amount of the balance. (Expense account) ● An account with a credit balance is closed by debiting the account for the amount of the balance. (Revenue account) The balance of each income statement account should be restored to zero before starting the next accounting period....