Intermediate financial accounting
Lecture 1 – Chapter 2: Accrual accounting and
income determination
Accounting equation
Assets are economic resources that will benefit the business in the
future, or simply, something the business owns that has value: Cash,
inventory, accounts receivable, repaid expenses, land, building,
furniture, supplies, etc.
Liability is a debt, that is, something you owe: Accounts payable,
notes payable, interest payable, salary payable, taxes payable, etc.
Owner’s equity is the owner’s claim to the assets of the business:
Capital, (-) withdrawals, revenues, (-) expenses, etc.
The double-entry system records the dual effects of each transaction:
Accrual accounting vs. cash accounting:
Net income = revenues – expenses
Cash-basis accounting:
Records only cash receipts and cash payments.
Ignores receivables, payables, and depreciation.
Accrual accounting:
Records the effect of each transaction as it occurs
Revenues are recorded when earned and expenses are recorded
when incurred.
Expenses are “matched” to revenues.
Under accrual accounting, revenues are recorded (recognized) in the
period when they are “earned” and become “realized or realizable”.
Expenses are the expired costs or assets that are used up in producing
those revenues. Expense recognition is tied to revenue recognition.
1
,Therefore, expenses are recorded in the same accounting period in which
the revenues are recognized. The approach of tying expense recognition to
revenue recognition is commonly referred to as the “matching principle”.
Accrual accounting can produce large differences between the firm’s
reported profit performance and the amount of cash generated from
operations. Frequently, however, accrual accounting earnings provide a
more accurate measure of the economic value added during the period
than do operating cash flows.
The modifications to the cash-basis results to obtain accrual earnings are
accomplished by means of “deferral” and “accrual” adjusting entries,
which are made at the end of each year under accrual accounting. These
adjusting entries fall into four categories:
1. Adjustments for prepayments.
2. Adjustments for unearned revenues.
3. Adjustments for accrued expenses.
4. Adjustments for accrued revenues.
Accrual accounting decouples measured earnings from operating cash
flows. Accrual accounting better matches economic benefit (revenues)
with economic effort (expenses, or the costs of producing the revenue),
thereby producing a measure of operating performance – accrual earnings
– that provides a more realistic picture of past economic activities.
Criteria for revenue recognition
According to GAAP, revenue is recognized at the earliest moment in time
that both of the following conditions are satisfied:
Condition 1: The critical event in the process of earning the revenue
has taken place.
Condition 2: The amount of revenue that will be collected is reasonably
assured and is measurable with a reasonable degree of
reliability.
2
, Lecture 2 – Chapter 3: Additional topics in income
determination
Revenues are usually recognized at the time of sale in most industry. This
is usually the earliest moment in time where condition 1 – the “critical
event” or being earned – and condition 2 – “measurability” or being
realized or realizable – are both satisfied. Revenue is recognized at the
earliest moment in time where this happens.
In some cases, conditions 1 and 2 are satisfied before the sale, for
example when production takes place on a long-term construction
contract. In other cases, conditions 1 and 2 may not be satisfied until after
the time of sale, for example – not until the cash is received on installment
sales when considerable uncertainty exists.
Revenue recognition prior to sale
The general revenue recognition criterion suggests that revenue should be
recognized when a long-term project is finished – completed contract
method. However, income statements prepared using the completed
contract period do not fairly report each period’s accomplishments when a
project spans more than one reporting period. The percentage-of-
completion method is designed to help address this problem.
Percentage-of-completion method
Before the construction begins, a formal contract has been signed. The
buyer is thus assured and the contract price is satisfied. Consequently,
both revenue recognition conditions are satisfied prior to the time of sale.
Condition 1: The critical event is actual construction, thus revenue is
earned over time as the project progresses toward completion.
Condition 2: Measurability is satisfied because there is a firm
contract with a known buyer at a set price.
In addition, construction costs can be estimated with reasonable
accuracy so that expenses can be matched with revenues.
Percentage-of-completion method: revenue is recognized in proportion to
the “work done” each period.
Step 1: Calculate the percentage of completion ratio by dividing costs
incurred to date by estimated total costs.
Costs incurred
Percentage of completion ratio=¿ date ¿
Estimated total costs
Step 2: Determine the estimated total profit on the contract by
comparing the contract price with the estimated total costs.
Step 3: Estimate the profit earned to date by multiplying the percentage
of completion ratio by the estimated total contract profit. (step 1 x step 2).
3
Lecture 1 – Chapter 2: Accrual accounting and
income determination
Accounting equation
Assets are economic resources that will benefit the business in the
future, or simply, something the business owns that has value: Cash,
inventory, accounts receivable, repaid expenses, land, building,
furniture, supplies, etc.
Liability is a debt, that is, something you owe: Accounts payable,
notes payable, interest payable, salary payable, taxes payable, etc.
Owner’s equity is the owner’s claim to the assets of the business:
Capital, (-) withdrawals, revenues, (-) expenses, etc.
The double-entry system records the dual effects of each transaction:
Accrual accounting vs. cash accounting:
Net income = revenues – expenses
Cash-basis accounting:
Records only cash receipts and cash payments.
Ignores receivables, payables, and depreciation.
Accrual accounting:
Records the effect of each transaction as it occurs
Revenues are recorded when earned and expenses are recorded
when incurred.
Expenses are “matched” to revenues.
Under accrual accounting, revenues are recorded (recognized) in the
period when they are “earned” and become “realized or realizable”.
Expenses are the expired costs or assets that are used up in producing
those revenues. Expense recognition is tied to revenue recognition.
1
,Therefore, expenses are recorded in the same accounting period in which
the revenues are recognized. The approach of tying expense recognition to
revenue recognition is commonly referred to as the “matching principle”.
Accrual accounting can produce large differences between the firm’s
reported profit performance and the amount of cash generated from
operations. Frequently, however, accrual accounting earnings provide a
more accurate measure of the economic value added during the period
than do operating cash flows.
The modifications to the cash-basis results to obtain accrual earnings are
accomplished by means of “deferral” and “accrual” adjusting entries,
which are made at the end of each year under accrual accounting. These
adjusting entries fall into four categories:
1. Adjustments for prepayments.
2. Adjustments for unearned revenues.
3. Adjustments for accrued expenses.
4. Adjustments for accrued revenues.
Accrual accounting decouples measured earnings from operating cash
flows. Accrual accounting better matches economic benefit (revenues)
with economic effort (expenses, or the costs of producing the revenue),
thereby producing a measure of operating performance – accrual earnings
– that provides a more realistic picture of past economic activities.
Criteria for revenue recognition
According to GAAP, revenue is recognized at the earliest moment in time
that both of the following conditions are satisfied:
Condition 1: The critical event in the process of earning the revenue
has taken place.
Condition 2: The amount of revenue that will be collected is reasonably
assured and is measurable with a reasonable degree of
reliability.
2
, Lecture 2 – Chapter 3: Additional topics in income
determination
Revenues are usually recognized at the time of sale in most industry. This
is usually the earliest moment in time where condition 1 – the “critical
event” or being earned – and condition 2 – “measurability” or being
realized or realizable – are both satisfied. Revenue is recognized at the
earliest moment in time where this happens.
In some cases, conditions 1 and 2 are satisfied before the sale, for
example when production takes place on a long-term construction
contract. In other cases, conditions 1 and 2 may not be satisfied until after
the time of sale, for example – not until the cash is received on installment
sales when considerable uncertainty exists.
Revenue recognition prior to sale
The general revenue recognition criterion suggests that revenue should be
recognized when a long-term project is finished – completed contract
method. However, income statements prepared using the completed
contract period do not fairly report each period’s accomplishments when a
project spans more than one reporting period. The percentage-of-
completion method is designed to help address this problem.
Percentage-of-completion method
Before the construction begins, a formal contract has been signed. The
buyer is thus assured and the contract price is satisfied. Consequently,
both revenue recognition conditions are satisfied prior to the time of sale.
Condition 1: The critical event is actual construction, thus revenue is
earned over time as the project progresses toward completion.
Condition 2: Measurability is satisfied because there is a firm
contract with a known buyer at a set price.
In addition, construction costs can be estimated with reasonable
accuracy so that expenses can be matched with revenues.
Percentage-of-completion method: revenue is recognized in proportion to
the “work done” each period.
Step 1: Calculate the percentage of completion ratio by dividing costs
incurred to date by estimated total costs.
Costs incurred
Percentage of completion ratio=¿ date ¿
Estimated total costs
Step 2: Determine the estimated total profit on the contract by
comparing the contract price with the estimated total costs.
Step 3: Estimate the profit earned to date by multiplying the percentage
of completion ratio by the estimated total contract profit. (step 1 x step 2).
3
