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Chapter 4

Income Measurement and


Accrual Accounting

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Learning Objectives
LO1 Explain the significance of recognition and measurement in
the preparation and use of financial statements.
LO2 Explain the differences between the cash and accrual bases
of accounting.
LO3 Describe the revenue recognition principle and explain its
application in various situations.
LO4 Describe the matching principle and the various methods
for recognizing expenses
LO5 Identify the four major types of adjusting entries and
prepare them for a variety of situations.

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Learning Objectives (continued)
LO6 Explain the steps in the accounting cycle and the
significance of each step.
LO7 Explain why and how closing entries are made at the end of
an accounting period.
LO8 Understand how to use a work sheet as a basis for
preparing financial statements (Appendix).

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Module 1 Accrual Accounting
Principles
The accrual basis of accounting provides
information to users of the statements that a
cash basis does not provide
The revenue recognition principle is important
in various situations
The matching principle is used for recognizing
expenses

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Accrual Accounting Principles
Recognition: process of recording an item as an
asset, a liability, a revenue, an expense, or the
like
Measurement: requires two choices to be made
1. The attribute to be measured
Historical cost
Current value
2. The unit of measureyardstick
Money

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Exhibit 4-1Recognition and
Measurement in Financial
Statements

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Cash and Accrual Bases of
Accounting
Cash basis: revenues are recognized when cash
is received and expenses are recognized when
cash is paid
Accrual basis: revenues are recognized when a
performance obligation is satisfied and
expenses are recognized when incurred

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Example 4-1Comparing the Cash
and Accrual Bases of Accounting

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Exhibit 4-2Comparing the Cash
and Accrual Bases of Accounting

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The Revenue Recognition Principle
Recognized in the income statement when a
performance obligation is satisfied
Revenues: Inflows of assets or settlements of
liabilities from:
Deliveringor producing goods
Rendering services
Conducting other activities

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Expense Recognition and the
Matching Principle
Association of revenue of a period with all of
the costs necessary to generate that revenue
Direct matching: associate revenues of a period with
their costs
Indirect matching: associate costs with a particular
period
Example: depreciation on building

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Example 4-3Comparing Three
Methods for Matching Costs with
Revenue

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Module 2 Adjusting Entries
Various types of adjustments are made by
companies and they are recorded in the
accounting system as adjusting entries

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Types of Adjusting Entries
Made at the end of an accounting period
Types of adjusting entries:
1. Cash paid before expense is incurred (Deferred
Expense)
2. Cash received before revenue is recognized
(Deferred Revenue)
3. Expense incurred before cash is paid (Accrued
Liability)
4. Revenue recognized before cash is received
(Accrued Asset)

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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 expense
Deferred revenue
A liability resulting from the receipt of cash before
the recognition of revenue
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Deferred Expense
Cashpaid before expense is incurred
Example:
Prepaid rent
Prepaid insurance
Office supplies
Property and equipment

Unexpired costs are assets


Written off and replaced with an expense as the
costs expire
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Example 4-4Adjusting a Deferred
Expense Account
Assume that on September 1, Nordstrom prepays $2,400 for an insurance
policy for the next 12 months. The entry to record the prepayment is as
follows:

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Example 4-4Adjusting a Deferred
Expense Account (continued)
An asset account, Prepaid Insurance, is recorded because the company will
receive benefits over the next 12 months
Because the insurance is for a 12-month period, $200 of benefits from the
asset expires at the end of each month

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Example 4-5Recording
Depreciation
Assume that on January 1, Nordstrom buys new store fixtures, for which it
pays $5,000. The entry to record the purchase is as follows:

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Example 4-5Recording
Depreciation (continued)
The adjustment to recognize depreciation is conceptually the same as the
adjustment to write off Prepaid Insurance. The asset account is reduced and
an expense is recognized
However, accountants normally use a contra account to reduce the total
amount of long-term tangible assets by the amount of depreciation

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Deferred Revenue
Cashreceived before revenue is earned
Example:
Insurance collected in advance
Subscriptions collected in advance
Gift certificates

Initially recorded as liabilities (unearned or


refundable receipts) and recorded as revenues
in future periods when earned

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Example 4-6Adjusting a Deferred
Revenue Account
In Example 4-4 involving the purchase of an insurance policy, the insurance
company received the cash paid by Nordstrom
The insurance company has a liability because it has taken cash from
Nordstrom but has not yet performed the service to recognize the revenue
The revenue will be recognized with the passage of time. This is the entry on
the books of the insurance company on September 1:

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Example 4-6Adjusting a Deferred
Revenue Account (continued)
The account Insurance Collected in Advance is a liability
The adjusting entry at the end of each month accomplishes two purposes: it
recognizes (1) the reduction in the liability and (2) the revenue each month
To decrease a liability with a debit and increase revenue with a credit:

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Example 4-7Adjusting a Gift Card
Deferred Revenue Account
The entry that Nordstrom would make upon receipt of $100 for a gift card is
as follows:

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Example 4-7Adjusting a Gift Card
Deferred Revenue Account
(continued)
Deferred Revenue is a liability
If the card is redeemed at a Nordstrom store on March 31, the entry on
Nordstroms books on this date would be as follows:

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Accrued Liability
Cash is paid after an expense is actually incurred
rather than before its incurrence
Examples:
Payroll
Taxes
Utilities

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Example 4-8Adjusting an Accrued
Liability for Wages
Assume that at one of its stores, Nordstrom pays a total of $280,000 in wages
on every other Friday
Assume that the last payday was Friday, May 31
The next two paydays will be Friday, June 14, and Friday, June 28. The journal
entry will be the same on each of these paydays:

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Example 4-8Adjusting an Accrued
Liability for Wages (continued)
On a balance sheet prepared as of June 30, a liability must be recognized
Assume that the store is open seven days a week and that the daily cost is
1/14th of the biweekly amount of $280,000, or $20,000:

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Example 4-8Adjusting an Accrued
Liability for Wages (continued)
Nordstrom will need to eliminate the liability of $40,000 for the last two days
of wages recorded on June 30 because the amount has now been paid
An additional $240,000 of expense has been incurred for the $20,000 cost
per day associated with the first 12 days in July
Finally, cash is reduced by $280,000, which represents the biweekly payroll

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Example 4-9Recording an

Accrued Liability for Interest
Assume that Granger Company takes out a 9%, 90-day, $20,000 loan with its
bank on March 1
Granger will repay the principal and interest on May 30
The entry on Grangers books on March 1 follows:

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Example 4-9Recording an
Accrued Liability for Interest
(continued)
The amount of interest that must be recognized as expense at the end of
March is one-third of $450 because one month of a total of three has passed
The adjusting entry for the month of March is as follows:

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Example 4-9Recording an
Accrued Liability for Interest
(continued)
The same adjusting entry is made at the end of April:

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Example 4-9Recording an
Accrued Liability for Interest
(continued)
The entry on Grangers books on May 30 when it repays the principal and
interest is as follows:

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Accrued Asset
Revenue earned before the receipt of cash
Example: Rent and interest are earned with the
passage of time and require an adjustment if
cash has not yet been received
Whenever a company records revenue before
cash is received, receivable is increased and
revenue is also increased

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Example 4-10Recording an

Accrued Asset
Assume that Grand Management Company rents warehouse space to a
number of tenants
Most of its contracts call for prepayment of rent for six months at a time
Its agreement with one tenant, however, allows the tenant to pay Grand
$2,500 in monthly rent anytime within the first ten days of the following
month
The adjusting entry on Grands books at the end of April, the first month of
the agreement, is as follows:

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Example 4-10Recording an

Accrued Asset
When the tenant pays its rent on May 7, the effect on Grands books is as
follows:

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Exhibit 4-3Accruals and Deferrals

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Exhibit 4-4Unadjusted Trial
Balance

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Exhibit 4-5Adjusted Trial Balance

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Module 3 Accounting Cycle and
Closing Entries
Various steps in the accounting cycle lead up to
a set of financial statements

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The Accounting Cycle
Series of steps performed each period and
culminating with the preparation of a set of
financial statements

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Exhibit 4-6Steps in the
Accounting Cycle

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The Use of a Work Sheet
Device used at the end of the period to gather
the information needed to prepare financial
statements without actually recording and
posting adjusting entries

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Closing Entries
Made at the end of an accounting period
Serve two purposes:
1. Return the balance in all nominal accounts to zero
2. Transfer the net income or loss and the dividends
to Retained Earnings

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Real and Nominal Accounts
Real accounts: balance sheet accounts
Permanent
Not closed at the end of the period
Nominal accounts: revenue, expense, and
dividend accounts
Temporary
Closed at the end of the period

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The Closing Process
Debit all revenue accounts and credit the sum to
Income Summarysingle entry is made
Credit all expense accounts and debit the sum to
Income Summarysingle entry is made
Debit or credit Income Summary depending on
balance
Debit if credit balance, then credit Retained Earnings
Credit if debit balance, then debit Retained Earnings

A credit is made to close the Dividends account


with an offsetting debit to Retained Earnings
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Example 4-12Preparing Closing
Entries

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Interim Financial Statements
Financial statements prepared monthly,
quarterly, or at other intervals less than a year
in duration

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Module 4 Accounting Tools: Work
Sheets
A work sheet can expedite the preparation of
financial statements at the end of the period

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Accounting Tools: Work Sheets
Used to aid in preparation of the statements at
the end of a period
The format for a work sheet includes two
columns each (debits and credits) for:
the unadjusted trial balance
the adjustments
the adjusted trial balance
the income statement
the balance sheet

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Review
LO1 Explain the significance of recognition and measurement in
the preparation and use of financial statements.
Determining which economic events should be recognized and how
they should be measured is critical for accounting information to be
useful.
Recognition drives how and when the effects of economic events are described
in the financial statements.
Measurement involves deciding on the attribute of an economic
event that must be measured and the appropriate unit of measure.

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Review
LO2 Explain the differences between the cash and accrual bases
of accounting.
Cash and accrual bases are two alternatives used to account for
transactions or economic events. They differ in the timing of when
revenues and expenses are recognized.
Under the accrual method, which is the focus of this text, revenues are
recognized when a performance obligation is satisfied and expenses are
recognized when incurred.
By contrast, under the cash method, revenues are recognized when cash is
received and expenses are recognized when cash is paid.
LO3 Describe the revenue recognition principle and explain its
application in various situations.
Revenues are inflows of assets (or reductions of liabilities), generally
from providing goods or services to customers.
Revenues are recognized when a performance obligation is satisfied.

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Review
LO4 Describe the matching principle and the various methods
for recognizing expenses
The matching principle attempts to associate expenses with the time
periods in which the expenditures help generate revenues.
This principle is particularly important with expenditures for items
that last for more than one accounting period. An example is the
depreciation of a building.

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Review
LO5 Identify the four major types of adjusting entries and
prepare them for a variety of situations.
Adjusting entries are made at the end of an accounting period to
update revenue or expense accounts in accordance with the revenue
recognition and matching principles.
There are four basic categories of adjusting entries:
Adjustments where cash is paid before expenses are incurreddeferred
expenses.
Adjustments where cash is received before revenues are recognizeddeferred
revenues.
Adjustments where expenses are incurred before cash is paidaccrued liabilities.
Adjustments where revenues are recognized before cash is receivedaccrued
assets.

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Review
LO6 Explain the steps in the accounting cycle and the
significance of each step.
The accounting cycle involves seven steps that are repeated each
period. (See Exhibit 4-6.)
Collecting and analyzing data and journalizing transactions occur on a continuous
basis.
Periodically, transactions are posted to accounts in the ledger.
At the end of the period, a work sheet is prepared, financial statements are
prepared, adjusting entries are recorded and posted, and accounts are closed.

LO7 Explain why and how closing entries are made at the end of
an accounting period.
Journal entries that close the nominal (temporary) accounts achieve
two important objectives:
They return the balance of all nominal accounts to zero so that the accounts are
ready to record activity for the next accounting period.
They transfer net income (loss) and dividends to Retained Earnings.

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Review
LO8 Understand how to use a work sheet as a basis for
preparing financial statements (Appendix).
A work sheet is a useful device for organizing the information
necessary to prepare financial statements without going through the
formal process of recording and posting adjusting entries.
The format for a work sheet includes two columns each (debits and credits) for
the unadjusted trial balance, the adjustments, the adjusted trial balance, the
income statement, and the balance sheet.

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End of Chapter 4

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