Chapter 4
Introduction
Financial Statement Assumptions
Economic
Entity
Cost
Principle
Time
Period
Going
Concern
Monetary
Unit
Economic Entity Concept
• Each entity has its own books, records
and financial statements that are separate
from owners
• No intermingling of personal and business
assets and liabilities or income and
expenses
Business
Books &
Records
Cost Principle
• Record assets at cost paid
to acquire them – their
historical cost
• Continue to value assets at
historical cost until sold
• More objective than market
value
Going Concern
• Assume business will
continue indefinitely
into the foreseeable
future
• Justifies use of
historical cost
Monetary Unit
• How we measure (e.g. U.S. dollar,
Japanese yen, Mexican peso, etc.)
• Assumes economic measure is
relatively stable; no adjustment for
inflation made in financial
statements
Time Period Assumption
• Assumes it is possible to break up an
entity’s earnings in discrete time
periods (a month, quarter, year)
• Necessary to provide users with financial
results on a timely basis
• Requires use of estimates
1
2
3
4
5
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7
8
9
10
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12
13
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31
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
We use the Accrual based approach
as required by Generally Accepted
Accounting Principles.
LO2
Revenue Recognition Principle
Revenue is recognized when realized or
realizable and earned—when we have
provided the goods or services.
LO3
Expense Recognition and The
Matching Principal
Balance Sheet
ASSETS:
Inventory
Supplies
Prepaid assets
PP&E
Intangibles
Income Statement
EXPENSES:
when sold
Cost of goods sold
as used
Supplies expense
Insurance expense
Rent expense
over period they
provide benefits
Depreciation expense
Amortization expense
Other expenses
(as incurred)
LO4
Matching Principle
Match expenses with associated revenues
Directly
Indirectly
over period they
provide benefits
Simultaneously
upon their
acquisition
e.g. Inventory
e.g. Buildings
e.g. Utilities
Types of Adjusting Entries
Deferred
expense
Accrued
asset
ALL RECOGNIZE
REVENUE OR
EXPENSES
BEFORE OR
AFTER CASH IS
EXCHANGED
Accrued
liability
Deferred
revenue
LO5
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
Deferred Expense Example #1
We pay rent for our office space one year in advance on
September 1
Initial journal entry:
9/1
Prepaid Rent
2,400
Cash
Monthly adjusting journal entry:
9/30 Rent Expense
200
Prepaid Rent
2,400
200
($2,400 annual × 1/12 = $200 per month for 12
months)
Deferred Expense Example #2
Purchase treadmill on January 1 for $5,000. Estimated useful
life is 7 years (84 months); estimated salvage value is $800
Initial journal entry:
1/1 Fitness equipment
5,000
Cash
Monthly adjusting journal entry:
1/31 Depreciation Expense
50
Accumulated Depreciation
($5,000 – $800) × 1/84 = $50 per month
for 84 months)
5,000
50
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
Deferred Revenue Example
On September 1, we received $2,400 in advance for a 12month subscription to our monthly magazine.
Initial journal entry:
9/1
Cash
2,400
Unearned Subscription Revenue (liability)
2,400
Monthly adjusting journal entry:
9/30
Unearned Revenue
Subscription Revenue
($2400 * 1/12 = 200
200
200
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
Accrued Liability Example #1
Pay biweekly wages of $28,000
At end of month, between pay periods:
Wages Expense
4,000
Wages Payable
4,000
Next payday:
Wages Payable
Wages Expense
Cash
4,000
24,000
28,000
Accrued Liability Example #2
On March 1, assume a 9%, 90-day, $20,000 loan is
taken out with a bank
Initial journal entry:
3/1 Cash
20,000
Note Payable
20,000
Monthly adjusting journal entry:
3/31 Interest Expense
150
Interest Payable
150
($20,000 principal × 9% × 3/12 = $450 for 3
months or $450/3 = $150 per month)
Accrued Asset
Revenue earned before cash is received
 Examples:
Revenue
• Rent
• Interest
 Record revenue (and corresponding
receivable) in period earned; receive
payment in a future period
Accrued Asset Example
Rent payment of $2,500 due within first 10 days of
month
First day of the month:
Rent Receivable
Rent Revenue
2,500
Upon receipt of cash:
Cash
Rent Receivable
2,500
2,500
2,500