4-1
Chapter 4
Income Measurement and
Accrual Accounting
After studying this chapter, students should be able to:
◼ Explain the significance of recognition and measurement in the preparation and use of financial
statements (Module 1–LO1).
◼ Explain the differences between the cash and accrual bases of accounting (Module 1–LO2).
INSTRUCTOR’S MANUAL
4–2
Chapter Outline
MODULE 1 ACCRUAL ACCOUNTING PRINCIPLES
Module 1
LO 1
Accrual Accounting Principles
Recognition
Accountants and managers need to know (1) what economic events should be communicated or recognized
in the financial statements, and (2) how the effects of these transactions be measured in the statements.
◼ Recognition is the process of formally recording or incorporating an item in the financial
statements of an entity as an asset, liability, revenue, expense or the like.
⚫ Financial statements are a form of communication between the entity and external users.
assets, etc.
Measurement
◼ Quantification of the economic effects on an entity.
◼ Measurement of an item in the financial statements requires that two decisions be made:
⚫ The attribute to be measured.
⚫ The unit of measure to be used.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
4-3
⚫ Current value is the amount of cash or its equivalent that could be received by selling an
asset currently.
Only an estimate until item is sold.
Perhaps more relevant, but less reliable than historical cost.
⚫ Because of the objective nature, historical cost is the attribute used to measure many of the
assets on the balance sheet. However, current value has increased in popularity in recent
years.
Summary of Recognition and Measurement in Financial Statements
◼ Purpose of financial statements is to communicate various types of economic information about a
company.
Module 1
LO 2
The Accrual Basis of Accounting
Comparing the Cash and Accrual Bases of Accounting
Accrual basis of accounting is the foundation for the measurement of income in accounting. Basic
difference between cash basis and accrual bases is one of timing of the recognition of revenues and
expenses. (Exhibits 4-1 and 4-2).
INSTRUCTOR’S MANUAL
4–4
Accounts Receivable created at time of sale. At time of sale, Accounts Receivable is
debited and Revenue is credited.
.
What the Income Statement and the Statement of Cash Flows Reveal
◼ Most business entities use the accrual basis of accounting.
⚫ Income statement and balance sheet reflect accrual basis.
Accrual Accounting and Time Periods
◼ Earning of income is a process that takes place over a period of time, rather than at any one point
in time.
Module 1
LO 3
The Revenue Recognition Principle
◼ Revenues are the inflows or other enhancements of assets of an entity or settlements of its
liabilities from delivering or providing goods, rendering services, or other activities that constitute
the entity’s ongoing major or central operations.
⚫ An asset is not always involved when revenue is recognized. Can result from the settlement of
a liability.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
4-5
Module
1
LO 4
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.
◼ Expenses are expired costs.
⚫ Indirect form of matching to recognize the benefits associated with certain types of costs.
Costs benefit many periods but not able to match them directly with a specific sale of a
product.
Matched with the periods during which they will provide benefits.
• Long term assets such as buildings and equipment.
• Depreciation is the process of allocating the cost of a tangible long-term asset over
its useful life.
• Depreciation expense is allocated to the periods to which the asset provides benefits.
• Utilities costs, telephone, and fuel for vehicles are expensed as they are incurred.
◼ Expenses are the outflows or other using up of assets or incurrence of liabilities from delivering or
producing goods, rendering services, or carrying out other activities that constitute the entity’s
ongoing major or central operations.
◼ Expenses come about in two ways:
INSTRUCTOR’S MANUAL
MODULE 2 ADJUSTING ENTRIES
Module
2
LO 5
Adjusting Entries
Adjusting entries are made at the end of the accounting period by a company using the accrual basis of
accounting.
Types of Adjusting Entries
◼ On a cash basis, no differences exist in the timing of revenue and the receipt of cash. The same
holds true for expenses.
⚫ Therefore, no adjusting entries are needed.
Four types of adjusting entries:
◼ (1) Deferred expense: cash paid before the expense is incurred (EXAMPLES 4-4 and 4-5)
⚫ Assets are often acquired before their actual use in the business.
⚫ As asset expires, it becomes an expense.
Unexpired costs are assets.
⚫ As the costs expire and the benefits are used up, the asset must be written off and replaced
with an expense.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
• A contra account, Accumulated Depreciation, is used to decrease the asset.
o Contra account – an account with a balance that is opposite that of a related
account.
◼ (2) Deferred revenue: cash received before revenue is earned (EXAMPLE 4-6 and 4-7)
⚫ Revenues collected in advance of being earned (deferred revenue).
⚫ When something is paid in advance, it is an asset on one company’s books and a liability on
the other company’s books.
◼ (3) Accrued liability: expense incurred before cash is paid (EXAMPLES 4-8 and 4-9)
⚫ Opposite of deferred expense.
⚫ Cash is paid after an expense is actually incurred.
⚫ Adjusting entry records expense even though no cash was paid.
⚫ The adjusting entry is an increase to an expense account (debit) and an increase (credit) to a
liability account.
⚫ When the expense is paid, the liability is reduced.
INSTRUCTOR’S MANUAL
4–8
Accruals and Deferrals
◼ Deferral is a term used to refer to a situation in which cash has been paid or received but the
expense or revenue has been deferred to a later time.
◼ Deferred expense – indicates that cash has been paid, but the recognition of expense has been
deferred.
◼ Accrual is a term used to refer to a situation in which no cash has been paid or received yet, but it
is necessary to recognize (accrue) an expense or a revenue.
◼ Accrued liability is recognized at the end of the period in cases in which an expense has been
incurred but cash has not yet been paid.
⚫ A liability resulting from the recognition of an expense before the payment of cash.
Summary of Adjusting Entries (Exhibit 4-3)
◼ Adjustments are internal transactions and do not involve other entities.
◼ Adjustments NEVER increase or decrease Cash.
◼ At least one balance sheet account and one income statement account are involved in an adjusting
entry.
An asset or liability account is adjusted with a corresponding change in a revenue or
expense account.
Comprehensive Example of Adjusting Entries
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
4-9
⚫ Can have accounts that were not on the unadjusted trial balance, but that were added during
the adjustment process
.
Ethical Considerations for a Company on the Accrual Basis
◼ Since adjusting entries are internal transactions and do not involve external parties, accountants
may be pressured within the organization to either speed or delay the recognition of certain
adjustments.
MODULE 3 ACCOUNTING CYCLE AND CLOSING ENTRIES
Module 3
LO 6
Accounting Cycle and Closing Entries
Accounting cycle: series of steps performed each period culminating with the preparation of a set of
financial statements (Exhibit 4-6).
◼ Steps in the Accounting Cycle:
1. Collect and analyze data from source documents.
2. Journalize transactions.
INSTRUCTOR’S MANUAL
4–10
The Use of a Work Sheet
◼ A work sheet (Step 4 in the accounting cycle) is 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.
⚫ With time a factor at the end of an accounting period, a work sheet allows the accountant to
gather and organize the information required to adjust the accounts without actually
Module 3
LO 7
The Closing Process
◼ Two types of accounts appear on an adjusted trial balance:
⚫ Real accounts: Balance sheet accounts are real accounts because they are permanent in
nature.
◼ Closing entries serve two important purposes:
⚫ To return the balances in all temporary or nominal accounts to zero to start the next
accounting period.
⚫ To transfer net income (or net loss) and the dividends of the period to the Retained Earnings
account.
◼ Four closing entries are needed:
⚫ Debit each revenue account; the sum of the debits is the single credit to the Income
Summary account.
This zeros out the revenue accounts.
A single entry is made to close out all revenue accounts.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
⚫ Credit each expense account; the sum of the credits is the single debit to the Income
Summary account.
This zeros out the expense accounts.
A single entry is made to close out all expense accounts.
Interim Financial Statements
◼ Interim statements – financial statements prepared monthly, quarterly, or at other intervals less
than a year in duration.
Appendix
Module 4
LO 8
Accounting Tools: Work Sheets
Work sheets are used to organize the information needed to prepare the financial statements without
recording and posting formal adjusting entries.
◼ No one single format for a work sheet.
◼ It is not a financial statement, but a tool to help the accountant with the preparation of the financial
statements.
INSTRUCTOR’S MANUAL
4–12
• These columns should balance.
⚫ 2. The Adjusting Entries Columns (columns 3 and 4):
• Adjustments needed at the end of the interim period.
• These columns should balance.
⚫ 3. The Adjusted Trial Balance Columns (columns 5 and 6):
• The amounts in these columns are computed by either adding or subtracting the
adjustments to/from the unadjusted trial balance amounts (columns 1 or 2 combined
with columns 3 and 4).
⚫ 4. The Income Statement Columns (columns 7 and 8):
• The revenue and expense accounts from the adjusted trial balance columns are
transferred to the income statement columns of the worksheet.
• These columns will not balance until net income or net loss is entered on the work
⚫ 5. The Balance Sheet Columns (columns 9 and 10):
• The assets, liabilities, and owners’ equity accounts from the adjusted trial balance
columns are transferred to the balance sheet columns of the work sheet.
• The income statement columns appear before the balance sheet columns in the
worksheet because the income statement is a subset of the balance sheet, and
information from the income statement columns flows into the balance sheet
columns.
CHAPTER 4 INCOME MEASUREMENT AND ACCRUAL ACCOUNTING
4-13
Lecture Suggestions
Module 1
LO 1
In order to successfully communicate results, two concepts must be understood. They are
recognition and measurement. Have students explain these concepts in their own words. Can all
assets be measured – can we measure the value of our employees or the research skills of the
scientists working on the formula for new drugs? Are items recognized differently under the cash
and accrual methods?
Module 1
LO 3
On a practical basis, revenue is recognized when the product or service is delivered to the
customer. There are exceptions that present challenges to the recognition process such as
franchises and long-term contracts. Have students think of some examples where it might be
difficult to determine when revenue should be recognized – long-term construction contracts, sales
with rights of return, gym memberships, etc.
Module 2
LO 6
Connect the concepts learned thus far. Point out that the analysis stage (first step in the accounting
cycle) is what students were doing when they put transactions down in accounting equation
format. This format in turn helps them decide how to journalize the transaction, using the
placement of the elements of the transaction in the accounting equation, and the rules of debit and
credit. Posting assigns the pieces of journal entries to T accounts. As a consequence, the most
INSTRUCTOR’S MANUAL