Chapter 3: Accrual Accounting Basics Revenues are recognized when resources are created as part of the organization's operating activities. Expenses are recognized when resources are consumed as part of operating activities. Question: What do we mean when we say that amounts are "recognized"? Important Point: The recognition of revenues and expenses, and hence net income, are not determined by when the cash is received or paid.
Revenue Recognition General Rule: Revenue is recognized when the firm has fulfilled its commitment to its customers. Examples: Consider the home delivery business. The following events occur during January 2001 Mr. X signs up as a customer. Mr. X agrees to pay you $40 per month for weekly deliveries. No cash is exchanged. You make 4 deliveries to Mrs. Y. Mrs. Y owes you $45 for the deliveries. You collect $50 from Mr. Z for deliveries made in December 2000. You collect $55 from Mrs. A for deliveries to be made in February 2001. You receive a $500 loan from the bank. You sell stock for $1,000 in cash. Question: For which of these events should Delivery, Inc. record revenue? Why?
Expense Recognition Product Costs: Costs directly associated with specific goods. Recognized when the goods are sold. Examples: costs to acquire or manufacture inventory, sales commissions. Period Costs: Costs that are not directly associated with specific goods. Recognized when the firm receives the benefit from the costs. Examples: Rent for the corporate headquarters, salaries of top management, interest paid on general borrowings.
Depreciation Expense When a firm purchases a long-term asset, it must spread the expense over the useful life of the asset. Example: If Delivery, Inc. purchases a truck for $20,000 and expects to use the truck for 4 years; Delivery, Inc. should record $5,000 in depreciation expense each year. Note: Depreciation is a method of allocating the cost of a long-term asset over its useful life. Depreciation starts when the asset is placed in service (is involved in the revenue generating process). o If I purchase the truck on January 1, and start deliveries on March 1, depreciation begins on March 1. Depreciation ends when the asset is taken out of service. o If I stop using the truck on September 1, I stop recording depreciation, even if I still have the truck in the garage. Depreciation does not reflect changes in the value of the asset. o It doesn t matter whether the actual value of the truck has gone up or down. You do not depreciate land o Land has an unlimited useful life.
Account Names Firms categorize transactions by accounts. Typical accounts are as follows: Balance Sheet Income Statement Assets Liabilities Expenses Revenues Cash Accts payable COGS Sales Revenue Accts. Rec. Unearned Rev. Wage expense Service Rev. Inventory Notes payable Interest exp. Etc. Equipment Etc. Etc. Etc. Owners Equity Common Stk. Retained Earnings Retained Earnings represent firm earnings (net income) that are retained, not paid out (dividends). Ending Retained Earnings = Beginning + Net Income - Dividends
Example Delivery, Inc. charges $10 per delivery. You are given the following information with regard to activity during 2000. Some customers pay in advance. Other customers are billed for the delivery after the deliveries take place. 1. Made 1,500 deliveries and billed customers. 2. Received advance payments for 300 deliveries. 3. On January 1, 2000 Delivery sold 1,000 shares of stock for $5 a share. 4. On January 1, 2000 Delivery took out a loan for $20,000 from the bank. Interest is 1% per month. 5. On January 1, 2000 Delivery purchases a truck for $20,000 and expects to use the truck for 4 years. 6. On January 1, 2000 Delivery pays $3,000 for a 2-year insurance policy. 7. Made 200 deliveries for customers that paid in advance. 8. Paid $750 for gasoline. 9. On January 1, 2000 hired an employee for $100 per week. At the end of the year, you still owed the employee for the last two weeks. (Assume a 52 week year).
Other Trans. Cash Assets Liab Equity Rev Exp Beg 1 2 3 4 5 6 7 8 End
Income Statement An income statement displays the revenues and expenses of a firm and the calculation of net income for a company for a specific period of time. Delivery, Inc. Income Statement For the year ended December 31, 2000 Account Name Amount
Balance Sheet A balance sheet shows the assets, liabilities and equity balances for a company at a specific point in time. Delivery, Inc. Balance Sheet As of December 31, 2000 Assets Liabilities and Owners Equity Account Name Amount Account Name Amount