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

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

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
earnedusually at point of sale
Exceptions:

Long-term contracts
Franchises
Commodities
Installment sales
Rent and interest

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)

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

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 rent on office space for one year on September 1
Initial journal entry:
9/1
Prepaid Rent
2,400
Cash
2,400
Monthly adjusting journal entry:
9/30 Rent Expense
200
Prepaid Rent
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
Initial journal entry:
1/1 Store fixtures
5,000
Cash
5,000
Monthly adjusting journal entry:
1/31 Depreciation Expense
75
Accumulated Depreciation
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 on
September 1
Initial journal entry:
9/1 Cash
2,400
Insurance Collected in Advance

2,400

Monthly adjusting journal entry:

9/30 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

Pay biweekly wages of $280,000
At end of month, between pay periods:
Wages Expense

40,000

Wages Payable

40,000

Next payday:

Wages Payable
Wages Expense
Cash

40,000
240,000
280,000

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:

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
2,500

Upon receipt of cash:

Cash
Rent Receivable

2,500
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

Nominal Accounts
Revenues

Expenses

Close to
Income
Summary

Normal
balance

Normal
balance

Close to
Income
Summary

$ XX

$ XX

$ XX

$ XX

Dividends
Normal
balance

Close to
Retained
Earnings

$ XX

$ XX

Zero out
nominal accounts
to start accumulation
of next periods
results

Closing Entries
Income Summary
$XX
from expense
accounts

$XX
from revenue
accounts

(Net loss) or net income

closed to Retained Earnings

Accounting Tools:
Work Sheets

Unadjusted Trial Balance

Begin byColumns
filling in the
trial balance accounts
and amounts

The Adjusting Entries Columns

Make adjustments;
formal journal entries
are prepared later

Adjusted Trial Balance Columns

The Income Statement Columns

Extend revenue and

expense account balances
to the income statement

The Balance Sheet Columns

Extend asset, liability,

and equity accounts to
the balance sheet