1 Keeping Score: Bases of Economic Measurement CHAPTER F6 © 2007 Pearson Custom Publishing.

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Keeping Score:Keeping Score:

Bases of EconomicBases of Economic

MeasurementMeasurement

CHAPTER F6

© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

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Explain the difference Explain the difference between between realityreality and and the the measurement of measurement of

realityreality..© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

Learning Objective 1:

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What is “Reality” in Business?What is “Reality” in Business? A firm performs the following A firm performs the following

functions:functions:1 .. it operates to generate revenues,.. it operates to generate revenues,2 .. it invests resources to enable .. it invests resources to enable

operations,operations,3 .. it finances its operations and .. it finances its operations and

investments with both internal and investments with both internal and external sources, andexternal sources, and

4 .. it makes decisions... it makes decisions.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Measurement of Measurement of RealityReality

An accounting system needs to record the An accounting system needs to record the reality of each business event.reality of each business event.

Unfortunately, there is often a distortion Unfortunately, there is often a distortion between the reality and the measurement of between the reality and the measurement of reality.reality.

No matter how accurately the measurement No matter how accurately the measurement of reality reflects reality, it is of reality reflects reality, it is notnot that that reality.reality.

© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Periodic Measurement Periodic Measurement ProblemsProblems

Many differences between “reality” and the Many differences between “reality” and the “measurement of reality” stem from the “measurement of reality” stem from the accountants need to measure activities for a accountants need to measure activities for a specific period (month, quarter, year, etc.).specific period (month, quarter, year, etc.).

If we didn’t apply this assumption of If we didn’t apply this assumption of “periodicity,”“periodicity,” then we would not be able to then we would not be able to prepare monthly financial statements or prepare monthly financial statements or annual reports.annual reports.


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Periodic Measurement Periodic Measurement ProblemsProblems

It is the “cut-off” at the end of the It is the “cut-off” at the end of the period that causes those problems. period that causes those problems. Accountants are basically required to Accountants are basically required to take the entire life-span of a business take the entire life-span of a business and chop it up into little chunks.and chop it up into little chunks.


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Periodicity ExamplePeriodicity Example Assume you are a house painter. On Dec. 20, Assume you are a house painter. On Dec. 20,

you agree to paint a house for a total fee of you agree to paint a house for a total fee of $3,000. You begin the work on December 28 $3,000. You begin the work on December 28 and you finish the job on January 6. The and you finish the job on January 6. The customer pays you the full amount on Jan. 7.customer pays you the full amount on Jan. 7.

When should the $3,000 be shown as a When should the $3,000 be shown as a revenue? (Let’s assume that you were about revenue? (Let’s assume that you were about 1/3 finished with the job as of December 31.)1/3 finished with the job as of December 31.)


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Apply the criteria for Apply the criteria for revenue and expense revenue and expense recognition under the recognition under the

cash basis of accounting cash basis of accounting to determine periodic net to determine periodic net

income.income.© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing


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Revenue and Expense Revenue and Expense RecognitionRecognition

When accountants say that a revenue or When accountants say that a revenue or expense has been expense has been recognizedrecognized, they , they mean that:mean that:1 the revenue or expense has been the revenue or expense has been

recordedrecorded in the accounting records in the accounting records (i.e., “the books”), and(i.e., “the books”), and

2 that it is being that it is being reportedreported on the on the financial statements of the business.financial statements of the business.


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Revenue and Expense Revenue and Expense RecognitionRecognition

There is no perfect way to determine There is no perfect way to determine when recognition should take place, thus when recognition should take place, thus we have to follow certain accounting we have to follow certain accounting rules and conventions.rules and conventions.

There are two basic approaches to There are two basic approaches to determining when to recognize revenues determining when to recognize revenues and expenses. These are two different and expenses. These are two different ways to measure reality.ways to measure reality.


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Determine periodic net Determine periodic net income applying the income applying the rules of revenue and rules of revenue and expense recognition expense recognition required by accrual required by accrual

accounting.accounting.© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing


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Two Bases of Two Bases of Economic Economic

MeasurementMeasurement Cash Basis:Cash Basis: The easy way! When cash The easy way! When cash

comes in, it’s a revenue; when cash comes in, it’s a revenue; when cash goes out, it’s an expense. (Some goes out, it’s an expense. (Some exceptions apply!)exceptions apply!)

Accrual Basis:Accrual Basis: Recognize revenues Recognize revenues when when “earned”“earned” and expenses when and expenses when “incurred.”“incurred.” The timing of the related The timing of the related cash inflow or outflow is irrelevant.cash inflow or outflow is irrelevant.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Cash Basis Financial Cash Basis Financial StatementsStatements

To prepare financial statements using To prepare financial statements using the cash basis of accounting:the cash basis of accounting:

cash inflowscash inflows (except from owners and (except from owners and creditors) are considered revenues , and creditors) are considered revenues , and

cash outflowscash outflows (except distributions to (except distributions to owners and repayments of principal to owners and repayments of principal to creditors) are considered expenses.creditors) are considered expenses.


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Cash Basis ExampleCash Basis ExampleAssume the following facts:Assume the following facts: You invested $25,000 to start a proprietorship,You invested $25,000 to start a proprietorship, During your first month of business, you had:During your first month of business, you had:

sales of inventory to customers totaling sales of inventory to customers totaling $20,000 (NOTE: $5,000 of the sales were $20,000 (NOTE: $5,000 of the sales were credit sales and were not collected in the first credit sales and were not collected in the first month.)month.)

purchases of inventory totaling $20,000 for purchases of inventory totaling $20,000 for which you paid cash to the supplier (one-half which you paid cash to the supplier (one-half is still on hand) ,is still on hand) , (continued on next slide)(continued on next slide)


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Cash Basis ExampleCash Basis Example In your first month you also:In your first month you also:

had employees that earned a total of $5,000. Because had employees that earned a total of $5,000. Because payday doesn’t coincide with the end of the month, you payday doesn’t coincide with the end of the month, you have only paid them $3,000 of the amount earned.have only paid them $3,000 of the amount earned.

paid for a one-year insurance premium of $2,400.paid for a one-year insurance premium of $2,400. incurred other operating expenses (utilities, etc.) incurred other operating expenses (utilities, etc.)

totaling $2,000 which were all paid with cash.totaling $2,000 which were all paid with cash. purchased equipment and fixtures at a cost of $12,000. purchased equipment and fixtures at a cost of $12,000.

You believe these assets will last 10 years.You believe these assets will last 10 years. borrowed $5,000 from the bank on the last day of the borrowed $5,000 from the bank on the last day of the

month because you were low on cash.month because you were low on cash.


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Cash Basis AnalysisCash Basis Analysis Analyzing this data according to the cash Analyzing this data according to the cash

basis of accounting:basis of accounting: you had revenues for the cash collected from you had revenues for the cash collected from

customers, but not for the cash you invested customers, but not for the cash you invested in the business, and not for the cash from the in the business, and not for the cash from the bank loan.bank loan.

you had expenses equal to the cash paid for you had expenses equal to the cash paid for all of the different purchases, the wages paid, all of the different purchases, the wages paid, and the other operating costs.and the other operating costs.


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My ProprietorshipIncome Statement

For the Month Ending January 31, 2007

Sales $15,000- Cost of goods sold 20,000Gross margin ($5,000)

Equipment/fixtures $12,000Wages expense 3,000Insurance expense 2,400Utilities etc. 2,000

Total operating expenses 19,400 Operating loss (Net loss) ($24,400)

Cash Basis Income Cash Basis Income StatementStatement


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My ProprietorshipStatement of Capital


Owner, Capital, 1/1/07 25,000$

ADD: Net Income (24,400) 600

LESS: Drawings - Owner, Capital, 1/31/07 600$

Cash BasisCash BasisStatement of CapitalStatement of Capital


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My Propietorship

Balance Sheet

January 31, 2007Assets Liabilities

Cash $5,600 Notes payable $5,000

Owners' equityCapital $600

Total assets $5,600 Total L & OE $5,600

Cash Basis Balance SheetCash Basis Balance Sheet


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Accrual BasisAccrual BasisFinancial StatementsFinancial Statements

The accrual basis of accounting does not The accrual basis of accounting does not focus on the timing of the cash flows, but focus on the timing of the cash flows, but rather on the timing of the event that results rather on the timing of the event that results in a revenue or expense.in a revenue or expense.

Definition of Definition of accrue:accrue: To come into being as To come into being as a legally enforceable claima legally enforceable claim..

The The keykey is to determine is to determine when to recognizewhen to recognize revenues and expenses for a business.revenues and expenses for a business.


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Explain the concept of Explain the concept of matching and describe matching and describe

how it relates to how it relates to depreciation.depreciation.



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Revenue RecognitionRevenue Recognition Under the accrual basis, revenue should Under the accrual basis, revenue should

be be recognizedrecognized when it is when it is “earned”“earned” and and you have earned revenue when you have you have earned revenue when you have a legally enforceable claim to receive a legally enforceable claim to receive something of value (usually cash) for something of value (usually cash) for the revenue.the revenue.

Cash may be received at the Cash may be received at the same timesame time that the revenue is earned, that the revenue is earned, afterafter the the revenue is earned, or revenue is earned, or beforebefore the revenue the revenue is earned.is earned.


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There are three questions that help determine There are three questions that help determine when revenue should be recognized:when revenue should be recognized:

Has title to the “goods” been transferred to the Has title to the “goods” been transferred to the customer?customer?

Has an exchange of “goods” (or services) Has an exchange of “goods” (or services) taken place?taken place?

Is the earnings process virtually complete? Is the earnings process virtually complete? (Has the business done all they need to do?)(Has the business done all they need to do?)

Revenue RecognitionRevenue Recognition


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Discussion QuestionsDiscussion Questions You earn $3,000 from a house painting You earn $3,000 from a house painting

job. When should you recognize the job. When should you recognize the revenue from this job if you use the:revenue from this job if you use the:

cash basis of accounting?cash basis of accounting? accrual basis of accounting? accrual basis of accounting?


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Expense RecognitionExpense Recognition

Under accrual accounting, an expense should Under accrual accounting, an expense should be recognized when you receive the benefit be recognized when you receive the benefit from the expense.from the expense.

Cash might be paid at the time the expense is Cash might be paid at the time the expense is incurred,incurred,

Cash might be paid after incurring the expense,Cash might be paid after incurring the expense, Cash might be paid before the expense is Cash might be paid before the expense is

incurred.incurred.


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Think about the following three situations:Think about the following three situations: 1. You pay a one-year insurance premium.1. You pay a one-year insurance premium. 2. You buy a scratch-off lottery ticket.2. You buy a scratch-off lottery ticket. 3. You pay your utility bill ten days after it 3. You pay your utility bill ten days after it

arrives in the mail.arrives in the mail. If you accounted for your life using the If you accounted for your life using the

accrual basis, does the timing of the cash accrual basis, does the timing of the cash outflow coincide with the recognition of outflow coincide with the recognition of expense? (Before, same time, or after?)expense? (Before, same time, or after?)

Discussion QuestionsDiscussion Questions


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Concept of MatchingConcept of Matching

The accounting principle that supports the The accounting principle that supports the accrual approach to recording accrual approach to recording transactions is known as the transactions is known as the matching matching principleprinciple..

Revenues that are recognized for a Revenues that are recognized for a specific time period should be matched specific time period should be matched with the expenses that were required (or with the expenses that were required (or used) in order to generate those revenues.used) in order to generate those revenues.


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There may be a There may be a direct cause and direct cause and effecteffect between expenses and between expenses and revenues. In this case, it is easy to revenues. In this case, it is easy to properly apply the matching properly apply the matching principle.principle.



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Example of cause and effect: U.S. Mail Example of cause and effect: U.S. Mail Order Company received a phone order Order Company received a phone order from a customer for a $100 item. U.S.M.O. from a customer for a $100 item. U.S.M.O. pays a $5 shipping charge on the order. pays a $5 shipping charge on the order.

The shipping expense is directly caused The shipping expense is directly caused by the sale, and the expense should be by the sale, and the expense should be recorded in the same time period as the recorded in the same time period as the sale, thus matching is achieved.sale, thus matching is achieved.



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There might There might NOTNOT be a direct cause and be a direct cause and effect between expenses and revenues. effect between expenses and revenues. Properly applying the matching principle Properly applying the matching principle is more difficult in this situation.is more difficult in this situation.

Solution #1: Solution #1: Allocation of expense to the Allocation of expense to the time periods that are benefitedtime periods that are benefited.. Example: two years’ rent paid in Example: two years’ rent paid in

advance should be split between the advance should be split between the two years.two years.



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If solution #1 is not reasonable, then use:If solution #1 is not reasonable, then use: Solution #2: Solution #2: Immediate recognition of Immediate recognition of

expense.expense. Use this approach if:Use this approach if:

a) there is no identifiable future benefit, or a) there is no identifiable future benefit, or b) if the future benefit cannot be reasonably b) if the future benefit cannot be reasonably

measured.measured.



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Example of Immediate Example of Immediate RecognitionRecognition

Many companies spend huge amounts of Many companies spend huge amounts of money for “research and development.” money for “research and development.” There is little question that these There is little question that these expenditures lead to future benefits for the expenditures lead to future benefits for the company. However, how do you estimate company. However, how do you estimate the dollar amounts of those benefits?the dollar amounts of those benefits?

Since we can’t reliably measure the future Since we can’t reliably measure the future benefits, R&D costs are expensed benefits, R&D costs are expensed immediately.immediately.


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Example of Cost AllocationExample of Cost Allocation One of the best examples of solution #1 One of the best examples of solution #1

(allocating the cost over time) is the (allocating the cost over time) is the depreciation of a long-term asset. Assume depreciation of a long-term asset. Assume that your company buys a delivery truck that your company buys a delivery truck that you plan to use for the next four years.that you plan to use for the next four years.

The purchase cost of the truck should not The purchase cost of the truck should not be an expense when you buy it, but should be an expense when you buy it, but should be “spread out” over the next four years.be “spread out” over the next four years.


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DepreciationDepreciation ISIS a procedure that a procedure that allocates cost over more than one allocates cost over more than one time period.time period.

Definition of depreciation: Definition of depreciation: a a systematic and rational systematic and rational allocation of the cost of a long-allocation of the cost of a long-lived item from asset to lived item from asset to expense.expense.

DepreciationDepreciation


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Depreciation Depreciation IS NOTIS NOT an attempt to an attempt to measure the “fair market value” of measure the “fair market value” of an asset that is owned by a an asset that is owned by a business.business.

It It IS NOTIS NOT necessarily a way of necessarily a way of determining how much of an asset’s determining how much of an asset’s value has been “used up.” value has been “used up.”



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To calculate the annual depreciation for an To calculate the annual depreciation for an asset, we need to make two estimates:asset, we need to make two estimates:

(1) the (1) the useful lifeuseful life of the asset (not of the asset (not necessarily the same as the total life of the necessarily the same as the total life of the asset), andasset), and

(2) the (2) the residual valueresidual value of the asset (i.e., of the asset (i.e., what it will be worth at the end of the useful what it will be worth at the end of the useful life).life).



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The The depreciable basedepreciable base is equal to the original is equal to the original cost minus the disposal value.cost minus the disposal value.

Example: Your company buys a computer for Example: Your company buys a computer for $7,000. Estimated useful life is 4 years and $7,000. Estimated useful life is 4 years and estimated disposal value is $1,000.estimated disposal value is $1,000.

The depreciable base is $6,000, and you would The depreciable base is $6,000, and you would recognize depreciation expense of $1,500 per recognize depreciation expense of $1,500 per year ($6,000 / 4 years).year ($6,000 / 4 years).



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DepreciationDepreciation Over the 4 years, most of the asset value is converted to Over the 4 years, most of the asset value is converted to

expense. The cost is spread over the periods benefited.expense. The cost is spread over the periods benefited.

YearDepr.

ExpenseAccum.Depr.

BookValue

2007 1,500 1,500 5,5002008 1,500 3,000 4,0002009 1,500 4,500 2,5002010 1,500 6,000 1,000


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How would the cost of the computer How would the cost of the computer system be treated if you were using the system be treated if you were using the cash basis?cash basis?

Look again at the depreciation schedule Look again at the depreciation schedule for the computer. Does the $4,000 book for the computer. Does the $4,000 book value at the end of 2010 represent what value at the end of 2010 represent what we could sell the system for at that time?we could sell the system for at that time?


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At the end of each accounting period, At the end of each accounting period, certain adjustments must be made prior to certain adjustments must be made prior to preparing the financial statements.preparing the financial statements.

These adjustments are necessary to These adjustments are necessary to ensure that all items of revenue and ensure that all items of revenue and expense have been properly recognized expense have been properly recognized during the period.during the period.

There are two basic types of adjustments: There are two basic types of adjustments: AccrualsAccruals and and Deferrals.Deferrals.

AdjustmentsAdjustments


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Describe the difference Describe the difference between accruals and between accruals and deferrals and provide deferrals and provide

examples of each.examples of each.© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing


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An accrual adjustment would be necessary An accrual adjustment would be necessary to recognize items that have not yet been to recognize items that have not yet been recorded in the accounting records.recorded in the accounting records.

An An accrued revenueaccrued revenue would be a revenue would be a revenue that has been earned but not yet recorded.that has been earned but not yet recorded.

An An accrued expenseaccrued expense would be an expense would be an expense that has been incurred, but not yet that has been incurred, but not yet recorded.recorded.

AccrualsAccruals


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Remember the house painting example. Remember the house painting example. You didn’t get paid until the job was You didn’t get paid until the job was completed. However, if you were completed. However, if you were preparing an accrual basis income preparing an accrual basis income statement at the end of December, you statement at the end of December, you would need to show $1,000 (1/3 of the would need to show $1,000 (1/3 of the total) of total) of accrued painting revenueaccrued painting revenue for the for the amount of work that you have completed amount of work that you have completed so far.so far.

Example of Accrued Example of Accrued RevenueRevenue


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To start your house painting business, To start your house painting business, you took out a three-year small business you took out a three-year small business loan at the local bank. You will pay back loan at the local bank. You will pay back the principal and all of the interest at the the principal and all of the interest at the end of three years. If the interest is end of three years. If the interest is $1,000 per year, you would have an $1,000 per year, you would have an accrued interest expenseaccrued interest expense of $1,000 each of $1,000 each year, even though you are not going to year, even though you are not going to pay until the third year. pay until the third year.

Example of Accrued Example of Accrued ExpenseExpense


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DeferralsDeferrals A deferral is an item that has been recorded, A deferral is an item that has been recorded,

but that should not be recognized as a but that should not be recognized as a revenue or expense until a later period.revenue or expense until a later period.

A A deferred revenuedeferred revenue would occur when cash would occur when cash is received in advance, but not yet earned.is received in advance, but not yet earned.

A A deferred expensedeferred expense would occur when cash would occur when cash has been paid in advance, but the expense has been paid in advance, but the expense has not been incurred (i.e., a prepayment).has not been incurred (i.e., a prepayment).


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Accrual Basis Financial Accrual Basis Financial StatementsStatements

Financial statements that are prepared on Financial statements that are prepared on the accrual basis will be the result of the the accrual basis will be the result of the proper application of all of the revenue and proper application of all of the revenue and expense recognition rules, and the proper expense recognition rules, and the proper adjustments at the end of the period for all adjustments at the end of the period for all of the accruals and deferrals.of the accruals and deferrals.

Let’s use the “My Proprietorship” example Let’s use the “My Proprietorship” example and make financials on the accrual basis.and make financials on the accrual basis.


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My ProprietorshipIncome Statement


Sales $20,000- Cost of goods sold 10,000Gross margin $10,000

Wages expense $5,000Utilities, etc. 2,000Insurance expense 200Depreciation exp. 100

Total operating expenses 7,300Operating income (Net income) $2,700

Accrual BasisAccrual BasisIncome StatementIncome Statement


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Consider the following statement as Consider the following statement as it relates to the accrual basis of it relates to the accrual basis of economic measurement: economic measurement:

““Net income is an opinion, cash is a Net income is an opinion, cash is a fact.”fact.”

What do you think it means?What do you think it means?


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My ProprietorshipStatement of Capital


Owner, Capital, 1/1/07 25,000$

ADD: Net Income 2,700 27,700$

LESS: Drawings - Owner, Capital, 1/31/07 27,700$

Accrual BasisAccrual BasisStatement of CapitalStatement of Capital


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My PropietorshipBalance Sheet

January 31, 2007Assets Liabilities

Cash $5,600 Notes payable $5,000Accts receivable 5,000 Wages payable 2,000 Inventory 10,000 Total liabilities $7,000

Prepaid insurance 2,200 Owners' equity

Equipment/fixtures 11,900 Capital 27,700 Total assets $34,700 Total L & OE $34,700

Accrual Basis Balance Accrual Basis Balance SheetSheet


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Contrast the cash basis Contrast the cash basis and accrual basis of and accrual basis of

economic measurement, economic measurement, describing the relative describing the relative

strengths and strengths and weaknesses of each.weaknesses of each.© 2007 Pearson Custom © 2007 Pearson Custom

PublishingPublishing


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Comparing the Two Comparing the Two BasesBases

The main strength of the accrual The main strength of the accrual basis is in the concept of the basis is in the concept of the matching principle, where revenues matching principle, where revenues and expenses are reported in the and expenses are reported in the same time period. This gives a same time period. This gives a better picture of past performance better picture of past performance as a means to predict future as a means to predict future performance.performance.


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The main strength of the cash basis The main strength of the cash basis is the increase in objectivity. It is is the increase in objectivity. It is easy to determine in which time easy to determine in which time period a cash flow took place.period a cash flow took place.


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The main weakness of the accrual basis is The main weakness of the accrual basis is that the focus is shifted away from cash that the focus is shifted away from cash (remember “cash is the ball”). For example, (remember “cash is the ball”). For example, you might have a positive net income but a you might have a positive net income but a negative cash flow.negative cash flow.


NetIncome

CashFlows


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The main weakness of the cash basis is The main weakness of the cash basis is the lack of matching between revenues the lack of matching between revenues and expenses.and expenses.

So which is better? The answer to that So which is better? The answer to that question may be in the eye of the question may be in the eye of the beholder, but Generally Accepted beholder, but Generally Accepted Accounting Principles are based on the Accounting Principles are based on the accrual accounting method.accrual accounting method.



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End of Chapter 6


1 Keeping Score: Bases of Economic Measurement CHAPTER F6 © 2007 Pearson Custom Publishing.

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Transcript of 1 Keeping Score: Bases of Economic Measurement CHAPTER F6 © 2007 Pearson Custom Publishing.