Chapter 4

Introduction

Financial Statement Assumptions

EconomicEntity

CostPrinciple

GoingConcern

MonetaryUnit

TimePeriod

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

BusinessBooks &Records

Owners’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 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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

Income Statement

PP&EIntangibles

as used

Balance Sheet

when sold

over period they provide benefits

ASSETS: EXPENSES:Cost of goods sold

Supplies expenseInsurance expenseRent expense

Depreciation expenseAmortization expense

Other expenses (as incurred)

LO4

Inventory

SuppliesPrepaid assets

Matching Principle

Directly

Indirectlyover period theyprovide benefits

Simultaneouslyupon theiracquisition

e.g. Inventory e.g. Buildings e.g. Utilities

Match expenses with associated revenues

Types of Adjusting Entries

ALL RECOGNIZE REVENUE OR

EXPENSES BEFORE OR

AFTER CASH IS EXCHANGED

Deferred expense

Accrued liability

Accrued asset

Deferredrevenue

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

We pay rent for our office space one year in advance 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 #1

Deferred Expense Example #2

Initial journal entry:1/1 Fitness equipment 5,000

Cash 5,000

Monthly adjusting journal entry:

1/31 Depreciation Expense 50 Accumulated Depreciation 50($5,000 – $800) × 1/84 = $50 per month for 84 months)

Purchase treadmill on January 1 for $5,000. Estimated useful life is 7 years (84 months); estimated salvage value is $800

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 12-month 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 200Subscription Revenue 200

($2400 * 1/12 = 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

At end of month, between pay periods:

Wages Expense 4,000

Wages Payable 4,000

Next payday:

Wages Payable 4,000Wages Expense 24,000

Cash 28,000

Pay biweekly wages of $28,000

Accrued Liability Example #2

Initial journal entry:3/1 Cash 20,000

Note Payable 20,000Monthly 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)

On March 1, assume a 9%, 90-day, $20,000 loan is taken out with a bank

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

Revenue

Accrued Asset Example

First day of the month:Rent Receivable 2,500

Rent Revenue 2,500

Upon receipt of cash:Cash 2,500

Rent Receivable 2,500

Rent payment of $2,500 due within first 10 days of month