Chapter Three: Income Measurement
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Economists refer to income as a measure of "better-offness." Thus, economic income represents an increase in command over goods and services. Such notions of income capture operating successes, as well as good fortune from holding assets that may increase in value. In contrast, accounting income tends to focus on the effects of transactions and events that are evidenced by exchange transactions. For example, land is recorded at its purchase price.
In recent years, however, accounting rules around the globe have increasingly reflected greater acceptance of fair value measurements for selected financial statement elements. Whether and when accounting should measure changes in value has long been a source of debate. This debate is ongoing, and rules that establish measurement principles will continually evolve.
Generalizing: (a) accounting measurements tend to be based on historical cost determined by reference to an exchange transaction with another party (e.g., a purchase) and (b) income is"revenues" minus "expenses" as determined by reference to those transactions. More specifically:
- Revenues -- Inflows and enhancements from delivery of goods and services that constitute central ongoing operations
- Expenses -- Outflows and obligations arising from the production of goods and services that constitute central ongoing operations
- Gains/Losses -- Like revenues/expenses, but from peripheral transactions or events
Thus, it may be more precisely said that income is equal to Revenues + Gains - Expenses - Losses. Be aware that in some countries revenues is an all-inclusive term, including both revenues and gains.
Although accounting income will typically focus on recording transactions and events that are exchange based, note that some items must be recorded even though there is not an identifiable exchange between the company and some external party. What types of nonexchange events logically should be recorded to prepare correct financial statements? How about the loss of an uninsured building from fire or storm? Clearly, the asset is gone, so it logically should be removed from the accounting records. This would be recorded as an immediate loss. Even more challenging may be to consider the journal entry: debit a loss (losses are increased with debits since they are like expenses), and credit the asset account (the asset is gone and is reduced with a credit).
Business activity is fluid. Revenue and expense generating activities are in constant motion. Just because it is time to turn a page on a calendar does not mean that all business activity ceases. But, for purposes of measuring performance, it is necessary to draw a line in the sand of time. A periodicity assumption is made that business activity can be divided into measurement intervals, such as months, quarters, and years.
Accounting must divide the continuous business process, and produce periodic reports. An annual reporting period may follow the calendar year by running from January 1 through December 31. Annual periods are usually further divided into quarterly periods containing activity for three months.
In the alternative, a fiscal year may be adopted, running from any point of beginning to one year later. Fiscal years often attempt to follow natural business year cycles, such as in the retail business where a fiscal year may end on January 31 (allowing all of the holiday rush, and corresponding returns, to cycle through). Note in the following illustration that the "20X8 Fiscal Year" is so named because it ends in 20X8:
Also consider that internal reports may be prepared on even more frequent monthly intervals. As a general rule, the more narrowly defined a reporting period, the more challenging it becomes to capture and measure business activity. This results because continuous business activity must be divided and apportioned among periods; the more periods, the more likely that ongoing transactionsmust be allocated to more than one reporting period. Once a measurement period is adopted, the accountant's task is to apply the various rules and procedures of generally accepted accounting principles (GAAP) to assign revenues and expenses to the reporting period. This process is called accrual-basis accounting. Accrue means to come about as a natural growth or increase. Thus, accrual-basis accounting is reflective of measuring revenues as earned and expenses as incurred.
Correctly assigning revenues and expenses to time periods is pivotal in the determination of income. It goes without saying that reported income is of great concern to investors and creditors, and its proper determination is crucial. Measurement issues can become complex. For example, if a software company sells a product for $25,000 (in year 20X1), and agrees to provide updates at no cost to the customer for 20X2 and 20X3, then how much revenue is "earned" in 20X1, 20X2, and 20X3? Such questions make accounting far more challenging than most realize. Suffice it to say that one would need more information about the software company to answer their specific question. But, there are basic rules about revenue and expense recognition that should be understood, and they will be introduced in following sections.
Before moving away from the periodicity assumption, and its accounting implications, there is one important factor to note. If accounting did not require periodic measurement, and instead, took the view that one could report only at the end of a process, measurement would be easy. For example, if the software company were to report income for the three-year period 20X1 through 20X3, then revenue of $25,000 would be easy to measure. It is the periodicity assumption that muddies the water. Why not just wait? Two reasons: first, one might wait a long time for activities to close and become measurable with certainty, and second, investors cannot wait long periods of time before learning how a business is doing. Timeliness of data is critical to its relevance for decision making. Therefore, procedures and assumptions are needed to produce timely data, and that is why the periodicity assumption is put in play.
To recognize an item is to record it into the accounting records. Revenue recognition normally occurs at the time services are rendered or when goods are sold and delivered. The conditions for revenue recognition are (a) an exchange transaction, and (b) the earnings process being complete.
For a manufactured product, should revenue be recognized when the item rolls off of the assembly line? The answer is no! Although production may be complete, the product has not been sold in an exchange transaction. Both conditions must be met. In the alternative, if a customer ordered a product that was to be produced, would revenue be recognized at the time of the order? Again, the answer is no! For revenue to be recognized, the product must be manufactured and delivered.
Modern business transactions frequently involve complex terms, bundled items (e.g., a cell phone with a service contract), intangibles (e.g., a software user license), order routing (e.g., an online retailer may route an order to the manufacturer for direct shipment), achievement of milestones (e.g., payment contingent on reaching research and development results), and so forth. It is no wonder that many accounting failures involve misapplication of revenue recognition concepts. The U.S. Securities and Exchange Commission has additional guidance, noting that revenue recognition would normally be appropriate only when there is persuasive evidence of an arrangement, delivery has occurred (or services rendered), the seller's price is fixed or determinable, and collectibility is reasonably assured.
- Associating cause and effect: Many costs are linked to the revenue they help produce. For example, a sales commission owed to an employee is based on the amount of a sale. Therefore, commission expense should be recorded in the same accounting period as the sale. Likewise, the cost of inventory delivered to a customer should be expensed when the sale is recognized. This is what is meant by associating cause and effect, and is also referred to as the matching principle.
- Systematic and rational allocation: In the absence of a clear link between a cost and revenue item, other expense recognition schemes must be employed. Some costs benefit many periods. Stated differently, these costs expire over time. For example, a truck may last many years; determining how much cost is attributable to a particular year is difficult. In such cases, accountants may use a systematic and rational allocation scheme to spread a portion of the total cost to each period of use (in the case of a truck, through a process known as depreciation).
- Immediate recognition: Last, some costs cannot be linked to any production of revenue, and do not benefit future periods either. These costs are recognized immediately. An example would be severance pay to a fired employee, which would be expensed when the employee is terminated.
It is important to note that receiving or making payments are not criteria for initial revenue or expense recognition. Revenues are recognized at the point of sale, whether that sale is for cash or a receivable. Expenses are based on one of the approaches just described, no matter when payment occurs. Recall the earlier definitions of revenue and expense, noting that they contemplate something more than simply reflecting cash receipts and payments. Much business activity is conducted on credit, and severe misrepresentations of income could result if the focus was simply on cash flow.
In the previous chapter, tentative financial statements were prepared directly from a trial balance. However, a caution was issued about adjustments that may be needed to prepare a truly correct and up-to-date set of financial statements. This occurs because of multi-period items (revenue and expense items that relate to more than one accounting period) and accrued items (revenue and expense items that have been earned or incurred in a given period, but not yet entered into the accounting records). In other words, the ongoing business activity brings about changes in account balances that have not been captured by a journal entry. Time brings about change, and an adjusting process is needed to cause the accounts to appropriately reflect those changes. These adjustments typically occur at the end of each accounting period, and are akin to temporarily cutting off the flow through the business pipeline to take a measurement of what is in the pipeline. This is consistent with the revenue and expense recognition rules.
There is simply no way to catalog every potential adjustment that a business may need to make. What is required is a firm understanding of a particular business's operations, along with a good handle on accounting measurement principles. The following discussion describes typical adjustments. Strive to develop a conceptual understanding of these examples. Critical thinking skills will then allow extension of these basic principles to most any situation. The specific examples relate to:
It is common to pay for goods and services in advance. Insurance is typically purchased by prepaying for an annual or semi-annual policy. Or, rent on a building may be paid ahead of its intended use (e.g., most landlords require monthly rent to be paid at the beginning of each month). Another example of prepaid expense relates to supplies that are purchased and stored in advance of actually needing them. At the time of purchase, such prepaid amounts represent future economic benefits that are acquired in exchange for cash payments. As such, the initial expenditure gives rise to an asset. As time passes, the asset is diminished. This means that adjustments are needed to reduce the asset account and transfer the consumption of the asset's cost to an appropriate expense account.
As a general representation of this process, assume that one prepays $300 on June 1 to receive three months of lawn mowing service. As shown in the following illustration, this transaction initially gives rise to a $300 asset on the June 1 balance sheet. As each month passes, $100 is removed from the balance sheet account and transferred to expense (think: an asset is reduced and expense is increased, giving rise to lower income and equity).
$300 is paid in advance on June 1 for three months of lawn mowing service
Examine the journal entries for this illustration, and take note of the impact on the balance sheet account for Prepaid Mowing (as shown by the T-accounts below):
Insurance policies are usually purchased in advance. Cash is paid up front to cover a future period of protection. Assume a three-year insurance policy was purchased on January 1, 20X1, for $9,000. By December 31, 20X1, $3,000 of insurance coverage would have expired (one of three years, or 1/3 of $9,000). The following entries would be needed to record the transaction on January 1 and the adjustment on December 31:
As a result of the above entry and adjusting entry, the income statement for 20X1 would report insurance expense of $3,000, and the balance sheet at the end of 20X1 would report prepaid insurance of $6,000 ($9,000 debit less $3,000 credit). The remaining $6,000 amount would be transferred to expense over the next two years by preparing similar adjusting entries at the end of 20X2 and 20X3.
Assume a two-month lease is entered and rent paid in advance on March 1, 20X1, for $3,000. By March 31, 20X1, half of the rental period has lapsed, and financial statements are to be prepared. The following entries would be needed to record the transaction on March 1, and adjust rent expense and prepaid rent on March 31:
In the illustration for insurance, the adjustment was applied at the end of December, but the rent adjustment occurred at the end of March. What's the difference? What was not stated in the first illustration was an assumption that financial statements were only being prepared at the end of the year, in which case the adjustments were only needed at that time. In the second illustration, it was explicitly stated that financial statements were to be prepared at the end of March, and that necessitated an end of March adjustment.
There is a moral to this: adjustments should be made every time financial statements are prepared, and the goal of the adjustments is to correctly assign the appropriate amount of expense to the time period in question (leaving the remainder in a balance sheet account to carry over to the next time period(s)). Every situation will be somewhat unique, and careful analysis and thoughtful consideration must be brought to bear to determine the correct amount of adjustment.
The initial purchase of supplies is recorded by debiting Supplies and crediting Cash. Supplies Expense should subsequently be debited and Supplies credited for the amount used. This results in expense on the income statement being equal to the amount of supplies used, while the remaining balance of supplies on hand is reported as an asset. The following illustrates the purchase of $900 of supplies. Subsequently, $700 of this amount is used, leaving $200 of supplies on hand in the Supplies account:
One might find it necessary to"back in"to the calculation of supplies used. Assume $200 of supplies in a storage room are physically counted at the end of the period. Since the account has a $900 balance from the December 8 entry, one "backs in" to the $700 adjustment on December 31. In other words, since $900 of supplies were purchased, but only $200 were left over, then $700 must have been used.
The following year is slightly more challenging. If an additional $1,000 of supplies is purchased during 20X2, and the ending balance at December 31, 20X2, is $300, then these entries would be needed:
The $1,000 amount is clear enough, but what about the $900 of expense? One must take into account that 20X2 started with a $200 beginning balance (last year's "leftovers"), purchases were an additional $1,000 (giving the total available for the period at $1,200), and the year ended with $300 of supplies on hand. Thus, $900 was used up during the period:
Long-lived assets like buildings and equipment will provide productive benefits to a number of periods. Thus, a portion of their cost is allocated to each period. This process is called depreciation. A subsequent chapter will cover depreciation in great detail. However, one simple approach is called the straight-line method, where an equal amount of asset cost is assigned to each year of service life.
By way of example, if a $150,000 truck with a 3-year life was purchased on January 1 of Year 1, depreciation expense would be $50,000 per year ($150,000/3 = $50,000). This expense would be reported on each year's income statement. The annual entry involves a debit to Depreciation Expense and a credit to Accumulated Depreciation (rather than crediting the asset account directly):
Accumulated depreciation is a unique account. It is reported on the balance sheet as a contra asset. A contra account is an account that is subtracted from a related account. As a result, contra accounts have opposite debit/credit rules. In other words, accumulated depreciation is increased with a credit, because the associated asset normally has a debit balance. The following statements show how accumulated depreciation and depreciation expense would appear for each year:
As one can see on each year's balance sheet, the asset continues to be reported at its $150,000 cost. However, it is also reduced each year by the ever-growing accumulated depreciation. The asset cost minus accumulated depreciation is known as the book value (or "net book value") of the asset. For example, at December 31, 20X2, the net book value of the truck is $50,000, consisting of $150,000 cost less $100,000 of accumulated depreciation. By the end of the asset's life, its cost has been fully depreciated and its net book value has been reduced to zero. Customarily the asset could then be removed from the accounts, presuming it is then fully used up and retired.
Often, a business will collect monies in advance of providing goods or services. For example, a magazine publisher may sell a multi-year subscription and collect the full payment at or near the beginning of the subscription period. Such payments received in advance are initially recorded as a debit to Cash and a credit to unearned Revenue. Unearned revenue is reported as a liability, reflecting the company's obligation to deliver product in the future. Remember, revenue cannot be recognized in the income statement until the earnings process is complete.
As goods and services are delivered (e.g., the magazines are delivered), the unearned Revenue is reduced (debited) and Revenue is increased (credited). The balance sheet at the end of an accounting period would include the remaining unearned revenue for those goods and services not yet delivered. This amount reflects the entity's obligation for future performance. Equally important, the reported revenue only reflects goods and services actually delivered. Following are illustrative entries for the accounting for unearned revenues:
Another type of adjusting journal entry pertains to the accrual of unrecorded expenses and revenues. Accruals are expenses and revenues that gradually accumulate throughout an accounting period. Accrued expenses relate to such things as salaries, interest, rent, utilities, and so forth. Accrued revenues might relate to such events as client services that are based on hours worked.
Few, if any, businesses have daily payroll. Typically, businesses will pay employees once or twice per month. Suppose a business has employees that collectively earn $1,000 per day. The last payday occurred on December 26, as shown in the 20X8 calendar that follows. Employees worked three days the following week, but would not be paid for this time until January 9, 20X9. As of the end of the accounting period, the company owes employees $3,000 (pertaining to December 29, 30, and 31). As a result, the adjusting entry to record the accrued payroll would appear as follows:
Before moving on to the next topic, consider the entry that will be needed on the next payday (January 9, 20X9). Suppose the total payroll on that date is $10,000 ($3,000 relating to the prior year (20X8) and another $7,000 for an additional seven work days in 20X9).
The journal entry on the actual payday needs to reflect that the $10,000 is partially for expense and partially to extinguish a previously established liability:
Most loans include charges for interest. The amount of interest therefore depends on the amount of the borrowing ("principal"), the interest rate ("rate"), and the length of the borrowing period ("time"). The total amount of interest on a loan is calculated as Principal X Rate X Time.
For example, if $100,000 is borrowed at 6% per year for 18 months, the total interest will amount to $9,000 ($100,000 X 6% X 1.5 years). However, even if the interest is not payable until the end of the loan, it is still logical and appropriate to accrue the interest as time passes. This is necessary to assign the correct interest cost to each accounting period. Assume that an 18-month loan was taken out on July 1, 20X1, and was due on December 31, 20X2. The accounting for the loan on the various dates (assume a December year end, with an appropriate year-end adjusting entry for the accrued interest) would be as follows:
Accrued rent is the opposite of prepaid rent discussed earlier. Recall that prepaid rent related to rent that was paid in advance. In contrast, accrued rent relates to rent that has not yet been paid, even though utilization of the asset has already occurred.
For example, assume that office space is leased, and the terms of the agreement stipulate that rent will be paid within 10 days after the end of each month at the rate of $400 per month. During December of 20X1, Cabul Company occupied the lease space, and the appropriate adjusting entry for December follows:
When the rent is paid on January 10, 20X2, this entry would be needed:
Many businesses provide services to clients under an understanding that they will be periodically billed for the hours (or other units) of service provided. For example, an accounting firm may track hours worked on various projects for their clients. These hours are likely accumulated and billed each month, with the periodic billing occurring in the month following the month in which the service is provided. As a result, money has been earned during a month, even though it won't be billed until the following month. Accrual accounting concepts dictate that such revenues be recorded when earned. The following entry would be needed at the end of December to accrue revenue for services rendered to date (even though the physical billing of the client may not occur until January):
The preceding discussion of adjustments has been presented in great detail because it is imperative to grasp the underlying income measurement principles. Perhaps the single most important element of accounting judgment is to develop an appreciation for the correct measurement of revenues and expenses. These processes can be fairly straightforward, as in the preceding illustrations. At other times, the measurements can grow very complex. A business process rarely starts and stops at the beginning and end of a month, quarter or year – yet the accounting process necessarily divides that flowing business process into measurement periods.
Keep in mind that the trial balance introduced in the previous chapter was prepared before considering adjusting entries. Subsequent to the adjustment process, another trial balance can be prepared. This adjusted trial balance demonstrates the equality of debits and credits after recording adjusting entries. Therefore, correct financial statements can be prepared directly from the adjusted trial balance. The next chapter provides a detailed look at the adjusted trial balance.
The mechanics of accounting for prepaid expenses and unearned revenues can be carried out in several ways. At left below is a "balance sheet approach" for Prepaid Insurance. The expenditure was initially recorded into a prepaid account on the balance sheet. The alternative approach is the "income statement approach," wherein the Expense account is debited at the time of purchase. The appropriate end-of-period adjusting entry establishes the Prepaid Expense account with a debit for the amount relating to future periods. The offsetting credit reduces the expense to an amount equal to the amount consumed during the period. Note that Insurance Expense and Prepaid Insurance accounts have identical balances at December 31 under either approach.
Accounting for unearned revenue can also follow a balance sheet or income statement approach. The balance sheet approach for unearned revenue is presented at left below. At right is the income statement approach, wherein the initial receipt is recorded entirely to a Revenue account. Subsequent end-of-period adjusting entries reduce Revenue by the amount not yet earned and increase unearned Revenue. Again, both approaches produce the same financial statement results.
The income statement approach does have an advantage if the entire prepaid item or unearned revenue is fully consumed or earned by the end of an accounting period. No adjusting entry would be needed because the expense or revenue was fully recorded at the date of the original transaction.
Generally accepted accounting principles require that a business use the accrual basis. Under this method, revenues and expenses are recognized as earned or incurred, utilizing the various principles introduced throughout this chapter. An alternative method in use by some small businesses is the cash basis. The cash basis is not compliant with GAAP, but a small business that does not have a broad base of shareholders or creditors does not necessarily need to comply with GAAP. The cash basis is much simpler, but its financial statement results can be very misleading in the short run. Under this easy approach, revenue is recorded when cash is received (no matter when it is earned), and expenses are recognized when paid (no matter when incurred).
The cash and accrual techniques may be merged together to form a modified cash-basis system. The modified cash-basis results in revenue and expense recognition as cash is received and disbursed, with the exception of large cash outflows for long-lived assets (which are recorded as assets and depreciated over time). However, to repeat, proper income measurement and strict compliance with GAAP dictates use of the accrual basis; virtually all large companies use the accrual basis.
Look at an example for Ortiz Company. Ortiz provides web design services to a number of clients and has been using the cash basis of accounting. The following spreadsheet is used by Ortiz to keep up with the business's cash receipts and payments. This type of spreadsheet is very common for a small business. The "checkbook" is in green, noting the date, party, check number, check amount, deposit amount, and resulting cash balance. The deposits are spread to the revenue column (shaded in tan) and the checks are spread to the appropriate expense columns (shaded in yellow). Note that total cash on hand increased by $15,732.70 (from $7,911.12 to $23,643.82) during the month.
The information from this spreadsheet was used to prepare the following cash-basis income statement. The increase in cash that is evident in the spreadsheet is mirrored as the cash-basis income:
Ortiz has been approached by Mega Impressions, a much larger web-hosting and design firm. Mega has offered to buy Ortiz's business for a price equal to "100 times" the business's monthly net income, as determined under generally accepted accounting principles. An accounting firm has been retained to prepare Ortiz's April income statement under the accrual basis. The following additional information is gathered in the process of preparing the GAAP-based income statement:
- The $9,000 deposit on April 7 was an advance payment for work to be performed equally during April, May, and June.
- The $11,788.45 deposit on April 20 was collection of an account for which the work was performed during January and February.
- During April, services valued at $2,000 were performed and billed, but not yet collected.
- Payroll -- The $700 payment on April 3 related $650 to the prior month. An additional $350 is accrued by the end of April, but not paid.
- Rent -- The amount paid corresponded to the amount used.
- Server -- The $1,416.22 payment on April 15 related $500 to prior month's usage.
- Administrative -- An additional $600 is accrued by the end of April, but not paid.
The accounting firm prepared the following accrual-basis income statement and corresponding calculations in support of amounts found in the statement. Although Ortiz was initially very interested in Mega's offer, he was very disappointed with the resulting accrual-basis net income and decided to reject the deal. This illustration highlights the important differences between cash- and accrual-basis accounting.
Cash-basis statements are significantly influenced by the timing of receipts and payments, and can produce periodic statements that are not reflective of the actual economic activity of the business for the specific period in question. The accrual basis does a much better job of portraying the results of operations during each time period. This is why it is very important to grasp the revenue and expense recognition concepts discussed in this chapter, along with the related adjusting entries that may be needed at the end of each accounting period.