McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"Accounting Clinic IIPrepared by: Nir YehudaWith contributions byStephen H. Penman Columbia UniversityMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-#Accounting Methods for Measuring PerformanceStrict cash basis of accounting.Revenues are recorded when cash is received and expenses are recorded when cash is paid.Accrual basis of accounting.Revenues and expenses are recorded on an economic basis independently of the actual flow of cash.McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-$Cash s. Accrual !asis of AccountingCash BasisCash BasisAccrual BasisAccrual Basis"asy to understand. #heoretically difficult.Provides a reliable picture of the the change in cash and the firm$s li%uidity.Provides a more reliable picture of the economic changes in wealth.Revenues and expenses are recorded according to cash inflows and outflows.Revenues and expenses are recorded according to economic change in wealth &the rules are discussed later on in this clinic'.Can be manipulated by changing the cash flows timing.Can be manipulated by the changing the recognition rules.McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-%Accrual Accounting( #he )uestionAt what point of the operating cycle of the firm should revenues and their related expenses be recogni*ed+McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-&Accrual Accounting( !asic RulesRevenue and expense should be recogni*ed at the first point at which both of the following criteria are met(,. #he revenue is earned. #he revenue-producing activity has been performed... #he revenue is either realized or realizable. #hat is/ the amount of cash to be collected can be estimated with reasonable accuracy.McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-7Revenue Recognition0or product sale transactions/ revenue is typically recogni*ed when when title passes to the customer.0or service transactions/ revenue is typically recogni*ed when the substantial performance occurred. !ecause of the intangibility of services/ it is often difficult to ascertain when a service consisting of more than a single act has been satisfactorily performed so as to warrant recognition of revenue.McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-'"xpense recognitionAccording to the matching principle/ selecting a revenue-recognition basis also determines whether related costs are expensed immediately or capitali*ed and expensed subse%uently. 1enerally/ expenses and losses are recogni*ed when an entity2s economic benefits are used up in the process of generating revenues. 3e recogni*e the following classification of costs(McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-(Product s. Period costsProduct costs - Costs directly related to specific revenues of the period &e.g./ products sold' are considered expenses of that period/ since they arise in the same transaction in which the revenue is recogni*ed. "xample are C41S and sales commissions. Period costs - Costs not directly related to particular revenues but rather to a period on the basis of transactions occurring in that period &e.g./ administrative salaries and head%uarters rent'/ or costs providing no discernible future benefits. #hey are recogni*ed as expenses when incurred. McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"0"arnings and Cash 0lowsRather than matching cash inflows and outflows/ earnings match revenues and expenses.Revenues 5 cash receipts 6revenue accrualsExpenses 5 cash disbursements 7 cash investments 6expense accrualsEarnings#he idea is to calculate a better measure of value added.Earnings 50ree cash flows 6 cash investments 6 accruals 7 net interestMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-""Revenue and "xpense AccrualsRevenue Accruals Revenue Accrualsalue added that is not cash flowAd8ustments to cash inflows that are not value addedEpense Accruals Epense Accrualsalue decreases that are not cash flowAd8ustments to cash outflows that are not value decreasesMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"2#he Revenue CalculationRevenue !Cash receipts "rom sales # Ne$ sales on credit

Cash received "or previous periods% sales Estimated sales returns and rebates &e"erred revenue "or cash received in advance o" sale# Revenue previously de"erredMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"##he "xpense CalculationEpense ! Cash paid "or epenses# Amounts incurred in 'eneratin' revenue but not yet paid Cash paid "or 'eneratin' revenues in "uture periods# Amounts paid in the past "or 'eneratin' revenues in the current periodMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"$Some "xamples of Accrual Accounting1. 1. Cash investment Cash investmentAccrual accounting boo9s cash investment to the balance sheet/ not as an expense to the income statement. "xample ( Plant2. 2. Revenue for which cash has not been received Revenue for which cash has not been receivedRevenue is recogni*ed when a sale is made to a customer/ not when she pays. So/ if a sale is made on credit/ revenue is boo9ed &in the income statement' and an accounts receivable is boo9ed on the balance sheet. McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"%Some "xamples of Accrual Accounting &Cont.'..An e!pense reco"ni#ed but not paid forAn e!pense reco"ni#ed but not paid forAn expense is reported when recogni*ed either as a product or a period cost. If the expense has not been paid for/ a liability is recogni*ed &as an accounts payable or accrued liability for example'. "xamples ( 3ages payable/ Rent payable/ Pensions payableMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"&Some "xamples of Accrual Accounting &Cont.'$.$.%!pense paid for but not reco"ni#ed.%!pense paid for but not reco"ni#ed.If cash is paid for an expense ahead of matching it with revenue/ it is recorded as a prepaid expense which is then transferred to the income statement in the subse%uent period when it matches against revenue. "xamples ( Prepaid wages &becomes wages expense in the future'/ Inventory &becomes Cost of 1oods Sold in the future'.McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2007All rights resere!.Clinic 2-"7Some "xamples of Accrual Accounting &Cont.'&.&.Asset used up becomes an e!penseAsset used up becomes an e!penseIf an investment is recorded as an asset in the balance sheet &see , above'/ its cost is subse%uently transferred to the income statement as a the asset is used up in generating revenue."xamples ( :epreciation/ amorti*ation of a patent