Chapter 4
Income Measurement and Accrual Accounting
Using Financial Accounting Information:
The Alternative to Debits and Credits, 6/e
by
Gary A. Porter and Curtis L. Norton
Copyright © 2009 South-Western, a part of Cengage Learning.
Recognition and Measurement
Recognition: formally
recording an item in
the financial statements
of an entity
...but at
current value
or historical
cost?
I know I
need to
record
this...
Measurement:
quantification of the
economic effects of
the item on the entity
LO1
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
Cash basis
statement
Accrual basis
statement
Statement of
Cash Flows
Income
Statement
Cash flows from
operating activities:
Net income:
$ 7,000
$(4,000)
What accounts for
the difference?
Revenue Recognition Principle
Revenue is recognized when realized and
earned—usually at point of sale
Exceptions:
 Long-term contracts
 Franchises
 Commodities
 Installment sales
 Rent and interest
LO3
Expense Recognition
Income Statement
Balance Sheet
EXPENSES:
ASSETS:
Inventory
Supplies
Prepaid assets
PP&E
Intangibles
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
e.g., Inventory
Indirectly over
period they
provide benefits
e.g., Buildings
Simultaneously
upon their
acquisition
e.g., Utilities
Types of Adjusting Entries
Deferred
expense
Accrued
asset
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
Prepay $2,400 for insurance for one year on September 1
Initial journal entry:
Balance Sheet
Assets
=
Liabilities + Stockholders’ +
Equity
Income Statement
Revenues − Expenses
Prepaid
Insurance 2400
Cash
(2400)
Monthly adjusting journal entry:
Prepaid Insurance (200)
Insurance Expense (200)
($2,400 annual × 1/12 = $200 per month for 12 months)
Deferred Expense Example #2
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:
Balance Sheet
Income Statement
Assets =
Liabilities + Stockholders’ + Revenues − Expenses
Equity
Store fixtures 5,000
Cash
(5,000)
Monthly adjusting journal entry:
Accumulated
Depreciation Expense
Depreciation (75)
(75)
($5,000 – $500) × 1/60 = $75 per month for 60 months)
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
Received $2,400 for an insurance policy in advance:
Initial journal entry:
Balance Sheet
Income Statement
Assets =
Liabilities + Stockholders’ + Revenues − Expenses
Equity
Cash 2,400
Insurance Collected
in Advance 2,400
Monthly adjusting journal entry:
Insurance Collected
in Advance (200)
Rent Revenue 200
($2,400 annual × 1/12 = $200 per month for 12 months)
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
Biweekly wages are $280,000
At end of month, between pay periods:
Balance Sheet
Assets =
Income Statement
Liabilities + Stockholders’ + Revenues − Expenses
Equity
Wages Payable
Wages Expense
40,000
(40,000)
Next payday:
Cash
(280,000)
Wages Payable
(40,000)
Wages Expense
(240,000)
Accrued Liability Example #2
On March 1, assume a 9%, 90-day, $20,000 loan is taken
Initial journal entry:
Balance Sheet
Assets =
Liabilities + Stockholders’ +
Equity
Cash
Note Payable
20,000
20,000
Monthly adjusting journal entry:
Interest Payable
150
Income Statement
Revenues -- Expenses
Interest Expense
(150)
($20,000 principal × 9% × 1/12 = $150/month )
Accrued Liability Example #2
Payment of note and interest:
Balance Sheet
Assets =
Income Statement
Liabilities + Stockholders’ + Revenues − Expenses
Equity
Cash (20450) Notes Payable (20000)
Interest Expense (150)
Interest Payable (300)
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
Accrued Asset Example
Rent payment of $2,500 due within first 10 days of month
First day of the month:
Balance Sheet
Assets = Liabilities + Stockholders’ +
Equity
Rent Receivable
2,500
Upon receipt of cash:
Cash 2,500
Rent Receivable
(2,500)
Income Statement
Revenues − Expenses
Rent Revenue 2,500
Steps in the Accounting Cycle
7. Close the
accounts
1. Collect and
analyze info
6. Record and
post adjusting
entries
5. Prepare
financial
statements
2. Journalize
transactions
3. Post
transactions to
general ledger
4. Prepare
work sheet
LO6
The Closing Process
 Real Accounts: Balance Sheet accounts are permanent
accounts and are never closed
 Balances are carried over from one period to the next
 Nominal Accounts: These are temporary accounts
 These accounts are closed at the end of the period and
these balances are not carried over from one period to
another
Zero out
 Revenues, Expenses and
nominal accounts
Dividends
to start accumulation
of next period’s
results
Closing Entries
Closing Entries serve two purposes:
(1) To return the balances in all temporary
or nominal accounts to zero to start
the next accounting period
(2) To transfer the net income (or net loss)
and the dividends of the period to the
Retained Earnings account
Interim Statements
 Financial statements prepared monthly, quarterly,
or at other intervals less than a year
 Used for internal purposes
End of Chapter 4