Income Measurement and Accrual Accounting
Recognition and Measurement in Financial Statements
Revenues:inflows of assets or reductions in liabilities from selling goods and services
Expenses:outflows of assets or increases in liabilities used up in generating revenues.
Recognitionformal recording of an item in financial statements, in words and numbers
Measurementquantify the effects of economic events numbers unit is money - dollars
historical cost - recorded for simplicity, verifiability, reliability
Current cost-relevant but less reliable
Only an estimate until item is sold
Net income= Revenues-Expenses.
Incomeamount of resources available for consumption at the end of a period and yet be as well off as it was at the beginning of the period.
CASH BASIS Versus ACCRUAL ACCOUNTING
So if we DEFINE PERIOD to be lifetime of a firm (which can only be defined for a firm with a finite life) then we are only interested in the earnings of a firm over its lifetime. In that case: a.just wait until the firm dissolves.
b.Add up all the cash inflows over its lifetime other than those for sale of own stock. c.Add up the cash outflows over its lifetime other those for stock repurchase or dividends. d.Find the difference between cash inflows and outflows and YOU HAVE NET INCOME. e.THE ABOVE IS ALWAYS TRUE.
However, if you DEFINE PERIOD TO BE ANY INTERVAL SMALLER THAN THE LIFE TIME when you wish to get information on earnings as intermediate feedback, then there is the following problem:
-transactions may not be complete on a cash to cash basis – because the earnings process is continuous –
Period1buy inventory for $5
Period2pay for inventory
Period3sell and deliver inventory for $15
Period4receive payment from customer.
KEY QuestionWhen should revenues and expenses be recognized?
One possibility is the cash basis recognize revenues at time of receiving cash and recognize expenses at the time of paying cash.
A toy retailer starts business on January 1, 2000. The retailer Mr. XYZ pays two months rent in advance on his store for $2000. He also purchases and pays for toys worth $35,000. However, during the month of January, he sold no toys. During February, he sells all the toys he has for $45,000 but collects only $5000 of that in cash. He expects the neighborhood children to pay the remaining $40000 in March.
Cost of toys-----------------
Limitations of Cash basis
1.expenses are not aligned in time with the revenue that they produce.
2.recognition of revenue is unduly postponed.
A Second possibility is the use of Accrual basis - depends upon when some critical event occurs.
What happens to income (accrual basis) using same example?
Cost of toys-----------------
Comparing the Cash And Accrual Bases of Accounting -Basic difference one of timing
Recognize Revenue whenRecognize Expense when
Cash Basis cash is received cash is paid
Accrual Basisrevenue is earned it is incurred
Exhibit 4-2 transparency
Accrualmatching of expenses with the corresponding revenues OR match resources used (expired assets- expenses)to generate revenue.
The accrual concept forces accountants and managers to focus on changes in owner’s equity rather than merely reporting changes to the cash or other assets.
The realization concept underlies the decision rules that accountants use in determining when...