Classnotes 3 (Quiz 2) Flashcards
What is Cash Accounting
method of accounting where revenues are recorded when cash is received and expended
What are the Advantages to Cash Accounting?
Provides reliable information about cash flows (cash is king!!)
Intuitive and easy to understand
Objective-timing and amount of transactions is clear
What are the Disadvantages to Cash Accounting
Delay in recording revenues/expenses until cash changes hands
Subject to manipulation – for example, firm can delay recording an expense by postponing cash payment
Poor matching of resources expended to benefits received
What is Accrual Accounting
method of accounting where revenues and expenses are recorded on an economic basis regardless of the actual flow of cash
Revenues recorded when benefits are earned
expenses recorded when resources are ‘consumed”(i.e., expended to produce benefits)
What are the advantages of accrual accounting
Better measurement of performance and matching of benefits and costs of transactions
Curtails manipulation of cash transactions
What are the disadvantages of accrual accounting
More difficult conceptually – requires more estimates
Cash is still king!!!
Non-cash financial manipulation through discretion and choice in accounting rules
What are the measurement principles of accrual accounting
Measurement involves both timing and amount of the recognition for both revenues and expenses: Timing of revenue recognition Measurement of amount of revenue Timing of expense recognition Measurement of amount of expenses
**Over the life of the firm: Cash Income = Accrual Income
What is the goal of the income statement
Goal:Present the operating results of firm for a given period of time (e.g., quarter, fiscal year)
NET INCOME = REVENUES – EXPENSES
Also known as
Statement of Operations
Statement of Earnings
GAAP Criteria for Revenue Recognition
Completion of the earnings process – The firm has delivered the goods to the customer or performed all or most of the services
i.e., it has earned the revenue
Receipt of assets from the customer –
Collection of cash or other benefits is reasonably assured though some uncertainty may remain (e.g., bad debts, warranties)
Cash (or other benefits) to be received is measurable
- Earned AND 2. Realized or Realizable
JE Example: Cash collection coincides with delivery or performance
- Deliver $500 of inventory to a customer in September
- Customer pays us $800 at the point of sale.
JE for September:
Cash (+A) $800
Sales Revenue (+R, +SE) $800
Cost of Goods Sold (+E, - SE) $500
Inventory (-A) $500JE Example: Cash collection after delivery.
Deliver $500 of inventory to a customer in September
Customer pays us $800 in October.
JE for September:
Accounts Receivable (+A) $800
Sales Revenue (+R, +SE) $800
Cost of Goods Sold (+E, - SE) $500
Inventory (-A) $500
JE for October:
Cash (+A) $800
Accounts Receivable (-A) $800JE Example: Cash collection before delivery. Customer pays us $800 in August.
Deliver $500 of inventory to a customer in September.
JE for August:
Cash (+A) $800
Unearned Revenue (+L) $800
JE for September:
Unearned Revenue (-L) $800
Sales Revenue (+R, +SE) $800
Cost of Goods Sold (+E, - SE) $500
Inventory (-A) $500
Whirlpool delivers $500,000 worth of washing machines to Best Buy in December. Best Buy pays Whirlpool in full in February.
When does Whirlpool recognize revenue?
December
Whirlpool’s Revenue JE for December (ignore COGS):
DR: Accounts Receivable (A+) $500,000
CR: Sales Revenue (+R, +SE) $500,000
Whirlpool’s Revenue JE for February:
DR: Cash (A+) $500,000
CR: Accounts Receivable (A-) $500,000
Mattel collects $300,000 cash from customers in December for toy sales made in October.
When does Mattel recognize revenue?
October
Mattel’s revenue JE for October:
DR: Accounts Receivable (+A) $300,000
CR: Sales Revenue (+R, +SE) $300,000
Mattel’s revenue JE for December:
DR: Cash (+A) $300,000
CR: Accounts Receivable (-A) $300,000
Donald Trump leases space to a tenant for the months of December and January for $20,000, all of which is paid for in cash in December.
When does Trump recognize revenue?
In December and January
Trump’s revenue JE for December:
DR: Cash (A+) 20,000
CR: Rent Revenue (+R, +SE) 10,000
CR: Unearned Revenue (+L) 10,000
Trump’s revenue JE for January:
DR: Unearned Revenue (-L) 10,000
CR: Rent Revenue (+R,+SE) 10,000
In December, Peet’s Coffee & Tea issues 50,000 shares of stock and receives $20 per share, which is $2 per share more than they expected.
When does Peet’s Coffee & Tea recognize revenue?
Cash in exchange for stock is not revenue. The company would increase common stock by $18 x 50,000 and Additional Paid in Capital by $100,000 ($2 x 50,000).
What are Revenue Adjustments
Revenues are measured by the cash or equivalent that the firm expects to receive.
Revenue is thus reduced by:
Sales discounts and allowances – customers may take advantage of discounts offered for prompt payment or may receive price adjustments on damaged merchandised
Sales returns – acknowledges that some customers may return goods
Define Expenses
Decreases in net assets (not necessarily cash) that arise in the process of generating revenue.
What is the expense recognition criteria:
Product costs - costs associated with the production of goods
record in the period in which the related revenue is recognized
Examples?
Period costs - cannot easily be matched with revenue - e.g., marketing or administrative costs
record in the period in which the firm uses the service or consumes the benefit of an asset
Principle for Expenses Example: Assume that we do not own a delivery truck. To make a September sale, we need to hire a third-party to deliver our product to the customer
Delivery occurs in September
$100 cash paid at the time of delivery
JE for September:
Delivery Expense (+E,-SE) 100
Cash (-A) 100
Principle for Expenses Example: Service performed before cash paid.
Delivery occurs in September
$100 cash paid in October
Journal Entry for September: Delivery Expense (+E,-SE) 100 Accounts Payable (+L) 100
Journal entry for October: Accounts Payable (-L) 100 Cash (-A) 100
Principle for Expenses Example: Service performed after cash paid.
$100 cash paid in advance in August
Delivery occurs in September
Journal Entry for August: Prepaid Delivery (+A) 100 Cash (-A) 100
Journal entry for September: Delivery Expense (+E, -SE) 100 Prepaid Delivery (-A) 100
Expense Example: Ford Motor buys engines costing $2,000,000 in December for cash.
Ford uses the engines to make cars at a total cost of $10,000,000 in December.
When does Ford Motor recognize an expense for the engines that they purchased?
What is Ford Motor’s expense entry for December?
Engines are a component of the final car that Ford will sell. Engines will stay in inventory accounts (moving from work-in-process to finished goods inventory) until the final car is sold.
What is Ford Motor’s expense entry for December?
There is not an expense entry for December. An expense will not be recognized until the car is sold.
Expense example: Ford sells cars costing $8,000,000 in December for a total selling price of $15,000,000.
What is the expense JE for December?
What is the expense JE for December? DR: Cash (+A) $15M DR: COGS (+E, -SE) $8M CR: Car Inventory (-A) $8M CR: Revenue (+R, +SE) $15M
Expense Example: Ford incurs $180,000 in salaries for its marketing staff in December.
When does Ford recognize salary expense?
What is the expense JE for December?
December
What is the expense JE for December?
DR: Salary Expense (+E, -SE) $180,000
CR: Salary Payable (+L) $180,000
Expense Example: Ford pays its auditor $50,000 in December for services to be rendered 50% in December and 50% in January.
When does Ford recognize an audit expense?
What is the expense JE for December?
50% of the expense is recognized in December and January, respectively.
What is the expense JE for December?
DR: Auditor Expense (+E, -SE) $25,000
DR: Prepaid Audit Expense (+A)$25,000
CR: Cash (-A) $50,000
Expense Example: Ford pays $1,200,000 in cash dividends in December.
When does Ford recognize and expense for dividends paid?
What is the expense journal entry for December?
Never. Dividends are not an expense. They are a return of capital, and thus, a reduction in retained earnings.
What is the expense journal entry for December?
There is no expense entry.
Expense Example: Ford buys a $500,000 machine press on December 15.
When does Ford recognize an expense for purchasing equipment?
A machine press is expected to benefit Ford for more than one year, and thus would be “capitalized”, or recorded as an asset. An expense would be recognized each period that the machine is placed in service.
More on this in the next lecture…
Timing of Revenue recognition
Revenue must have been “earned,” and amount to be received can be estimated with reasonable certainty (“realized or realizable”).
SEC interpretation of revenue recognition
Persuasive evidence of an exchange agreement exists, and
Delivery of goods or services has occurred, and
Seller’s price to buyer is fixed or determinable, and
Collectability is reasonably assured.
Which Statement: How did cash (on the balance sheet) change?
Look at Statement of Cash Flows
Which Statement: How did equity (on the balance sheet) change?
Look at Statement of Stockholders’ Equity
Which Statement: How did operations affect retained earnings (on the balance sheet)?
Look at Statement of Income
What is the Income Statement
Reports the result of a company’s operating activities over a period of time. It details amounts for revenues and expenses, and the difference between these two amounts is net income.
Revenue is the increase in equity that results from selling goods or services. Expense is the cost incurred to generate revenue. Net income is the increase in equity AFTER subtracting expenses from revenues.
Revenues - Expenses = Net Income
What is the balance sheet
a balance sheet reports a company’s financial position at a point in time. It summarizes the result of the company’s investing and financing activities by listing amounts for assets, liabilities, and equity. The balance sheet is based on the equation:
Assets = Liabilities + Equity
What is the statement of stockholders’ equity
this reports the changes in the equity accounts over a period of time. It details and classifies changes into three categories:
Contributed capital (includes common stock, and additional paid-in capital) Retained Earnings (includes cumulative net income or loss, and deducts dividends) Other stockholders' equity
What is an account
a record of increases and decreases for each asset, liability, equity, revenue, or expense.
What is the statement of cash flows
a financial document that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities
The statement of cash flows reports net cash flows from operating, investing, and financing activi-ties over a period of time
