Chapter 4: Adjusting the accounts and preparing financial statements

4.1: Measurement of profit
Profit = Income – Expense
• Profit may be recognized as either a cash basis or accrual basis:
• Cash Basis: Income (inc. revenues) is recorded in the period in which cash is received and expenses are recorded in the period in which cash is paid.
- This method does not recognize income when goods are sold and services are performed on credit
- Costs of goods and services consumed during the current period, but not paid for, are recognized as expenses in a subsequent period when cash is paid
- Good for small businesses, not so good for businesses whom conduct most of activities on credit or government.
• Accrual basis: Income (inc. revenues) is recognized in the period in which the expected inflow of economic benefits can be measured in a faithful and verifiable manner i.e. in the period in which a business sells goods or performs services under a contractual agreement.
- Provides a faithful representation of inflows and consumptions
Income (inc. revenues):
- Income represents increases in economic benefits during the period in the form of inflows or exchangements of assets or of decreases in liabilities that result in increased equity.
Expenses:
- Expenses recognized in the period which they are consumed
- Costs incurred and expected to provide economic benefits in future period represents unexpired cost, is an asset recorded on the balance sheet
- Cost of assets that have been consumed during the current period are recorded in income statement as expenses – expired costs, deducted from income (revenues) to determine profit.
Temporary (nominal) and permanent (real) accounts:
- Separate accounts made for each major type of income and expense
- To facilitate preparation of next period income statement, all income/expenses are reduced to a zero balance at