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Chapter 4 - Income Measurement & Accrual Accounting: Recognition & Measurement in Financial Statements

1) The document discusses key accounting concepts related to income measurement and accrual accounting including recognition, measurement, the revenue recognition and matching principles, and adjusting entries. 2) It explains that under accrual accounting, revenues are recognized when earned and expenses when incurred, rather than when cash is received or paid like under cash accounting. 3) There are four types of adjusting entries needed to align accrual accounting with the timing of cash flows: deferred expenses, deferred revenue, accrued liabilities, and accrued assets.

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Hareem Zoya Warsi
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34 views

Chapter 4 - Income Measurement & Accrual Accounting: Recognition & Measurement in Financial Statements

1) The document discusses key accounting concepts related to income measurement and accrual accounting including recognition, measurement, the revenue recognition and matching principles, and adjusting entries. 2) It explains that under accrual accounting, revenues are recognized when earned and expenses when incurred, rather than when cash is received or paid like under cash accounting. 3) There are four types of adjusting entries needed to align accrual accounting with the timing of cash flows: deferred expenses, deferred revenue, accrued liabilities, and accrued assets.

Uploaded by

Hareem Zoya Warsi
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Chapter 4 – Income Measurement & Accrual Accounting

Recognition & Measurement in Financial Statements


• Recognition: the process of recording an item in the financial statements as an asset, a liability, a
revenue, an expense, or the like.
• To successfully communicate information to the users of financial statements, accountants and
managers must answer two questions:
1. What economic events should be communicated, or recognized, in the statements?
2. How should the effects of these events be measured in the statements?

Recognition
• Recognition: the process of recording an item in the financial statements as an asset, a liability, a
revenue, an expense, or the like.
• Items such as assets, liabilities, revenues, and expenses depicted in financial statements are
representations.
• Since the general purpose behind financial statements is providing useful information to external
users, recognition plays an important role in identifying and including that “useful” information.

Measurement
• Accountants depict a financial statement item in both words and numbers.
• The accountant must quantify the effects of economic events on the entity in order to see the
financial impact of that event on the entity.
• Measurement of an item in financial statements requires that two choices be made:
1. The accountant must decide on the attribute to be measured.
2. A scale of measurement, or unit of measure, must be chosen.
• Cost is the amount of cash or its equivalent paid to acquire the asset.
• Historical cost: the amount paid for an asset and used as a verifiable basis for recognizing it on the
balance sheet and carrying it on later balance sheets.
• Current value: the amount of cash or its equivalent that could be received by selling an asset
currently.
• The choice between current value and historical cost as the attribute to be measured is a good
example of the trade-off between relevance and reliability, respectively.
• Because of its objective nature, historical cost is the attribute used to measure many of the assets
recognized on the balance sheet.
• Money is something accepted as a medium of exchange or as a means of payment.

The Accrual Basis of Accounting


Comparing the Cash and Accrual Bases 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 earned and expenses
are recognized when incurred.
Accrual Accounting and Time Periods
• We assume that it is possible to prepare an income statement that fairly reflects the earnings of a
business for a specific period of time, such as a month or a year.
• It is somewhat artificial to divide the operations of a business into periods of time as indicated on
a calendar because earnings take place over a period of time and not at a specific point in time.
• Stockholders, bankers, and other interested parties cannot wait until a business liquidates to make
decisions, however. They need information on a periodic basis. Thus, the justification for the
accrual basis of accounting lies in the needs of financial statement users for periodic information
on the financial position and the profitability of the entity.

The Revenue Recognition Principle


• Revenues: inflows of assets or settlements of liabilities from delivering or producing goods,
rendering services, or conducting other activities.
• An asset is not always involved when revenue is recognized. The recognition of revenue may result
from the settlement of a liability rather than from the acquisition of an asset.
• Entities generate revenue in different ways: some companies produce goods, others distribute or
deliver the goods to users, and still others provide some type of service.
• Revenue recognition principle: revenues are recognized in the income statement when they are
realized, or realizable, and earned.
• Revenues are realized when goods or services are exchanged for cash or claims to cash, usually at
the time of sale (at the time the product or service is delivered to the customer).
• In some cases, revenue is earned continuously over time. In these cases, a product or service is
not delivered at a specific point in time; instead, the earnings process takes place with the passage
of time. Rent and interest are two examples.

Expense Recognition and the Matching Principle


• An asset ceases being an asset and becomes an expense when the economic benefits from having
incurred the cost have expired. Assets are unexpired costs, and expenses are expired costs.
• Matching principle: the association of revenue of a period with all of the costs necessary to
generate that revenue.
• The classic example of direct matching is cost of goods sold expense with sales revenue.
• Another example is the commission paid to a salesperson can be matched directly with the sale.
• An indirect form of matching is used to recognize the benefits associated with certain types of
costs, most noticeably long-term assets such as buildings and equipment.
 Depreciation is the process of allocating the cost of a tangible long-term asset to its useful life.
Depreciation Expense is the account used to recognize this type of expense.
• The benefits associated with the incurrence of certain other costs are treated in accounting as
expiring simultaneously with the acquisition of the costs as they have no future benefit.
• Costs incurred for purchases of merchandise result in an asset, Merchandise Inventory, and are
eventually matched with revenue at the time the product is sold.
• Costs incurred for office space result in an asset, Office Building, which is recognized as
Depreciation Expense over the useful life of the building.
• The cost of heating and lighting benefits only the current period and thus is recognized
immediately as Utilities Expense.
• Expenses: outflows of assets or incurrences of liabilities resulting from delivering goods, rendering
services, or carrying out other activities.

Accrual Accounting and Adjustments


• Adjusting Entries: journal entries made at the end of a period by a company using the accrual basis
of accounting.
• Adjusting entries are not needed if a cash basis is used. The very nature of the accrual basis results
in the need for adjusting entries.
• Whenever a company records revenue before cash is received, some type of receivable is
increased, and revenue is also increased.

Types of Adjustments
• There are 4 types of adjustments:
1. Cash paid before expense is incurred (deferred expense).
2. Cash received before revenue is earned (deferred revenue).
3. Expense incurred before cash is paid (accrued liability).
4. Revenue earned before cash is received (accrued asset).
• There are 4 types of adjustments because:
1. On a cash basis, no differences exist in the timing of revenue and the receipt of cash. The
same holds true for expenses.
2. On an accrual basis, revenue can be earned before or after cash is received. Expenses can be
incurred before or after cash is paid. Each of these four distinct situations requires a different
type of adjustment at the end of the period.

1. Deferred Expense
• Assets are often acquired before their actual use in the business.
• As the costs expire and the benefits are used up, the asset must be written off and replaced
with an expense.
• Depreciation is the process of allocating the cost of a long-term tangible asset over its
estimated useful life.
 The accountant does not attempt to measure the decline in value of the asset but tries to
allocate the cost of the asset over its useful life.
• Two estimates must be made in depreciating the fixtures: the useful life of the asset and the
salvage value of the fixtures at the end of their useful lives. Estimated salvage value is amount
a company expects to receive when it sells an asset at the end of its estimated useful life.
• Straight-line method: the assignment of an equal amount of depreciation to each period.
• Contra account: an account with a balance that is opposite that of a related account.
• Companies use a contra account for depreciation rather than simply reduce the long-term
asset directly because if the asset account were reduced each time depreciation was
recorded, its original cost would not be readily determinable from the accounting records.
2. Deferred Revenue
• One company’s asset is another company’s liability.
• In such scenarios, the revenue is earned over the passage of time, but the payment is made
beforehand.
• The adjustment for this case, at the end of each month, accomplishes two purposes: it
recognizes the reduction in the liability and the revenue earned each month.
• Examples of this include prepaid insurance, gift cards, subscriptions, etc.

3. Accrued Liability
• Cash is paid after an expense is actually incurred rather than before its incurrence.
• Examples: Many normal operating costs, such as payroll, various types of taxes, and utilities.
• Another typical expense incurred before the payment of cash is interest.

4. Accrued Asset
• Revenue is sometimes earned before the receipt of cash.
• Rent and interest are earned with the passage of time and require an adjustment if cash has
not yet been received.

Accruals & 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 expense.
• Because a deferred expense represents a future benefit to a company, it is an asset. Also called
prepaid expense. Prepaid insurance and office supplies are deferred expenses.
• An adjustment is made periodically to record the portion of the deferred expense that has expired.
• Deferred revenue: a liability resulting from the receipt of cash before the recognition of revenue.
• Because a deferred revenue represents an obligation to a company, it is a liability. Also called
unearned revenue. Rent collected in advance is deferred revenue.
• The periodic adjustment recognizes the portion of the deferred revenue that is earned in that
period.
• Accrual: cash has not yet been paid or received but expense has been incurred or revenue earned.
• Accrued liability: a liability resulting from the recognition of an expense before the payment of
cash. Wages payable and interest payable are examples.
• Accrued asset: an asset resulting from the recognition of a revenue before the receipt of cash.
Rent receivable is an example.
The Accounting Cycle
• Accounting cycle: a series of steps performed each period and culminating with the preparation
of a set of financial statements.
• Some of the steps, such as journalizing transactions, are performed continuously, while others,
such as preparing adjusting entries, are performed only at the end of the period.
• Adjustments are one key component in the accounting cycle.
• Transactions are posted to the accounts on a periodic basis.
• The frequency of posting to the accounts depends on two factors: the type of accounting system
used by a company and the volume of transactions.
• 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.

• 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 the period.
• Closing entries: journal entries made at the end of the period to return the balance in all nominal
accounts to zero and transfer the net income or loss and the dividends to Retained Earnings.
• Interim statements: financial statements prepared monthly, quarterly, or at other intervals less
than a year in duration.
 Many companies prepare these statements for their own internal use.

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