IngramSM03rev - CHAPTER 3 Measuring Revenues and Expenses...

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Unformatted text preview: CHAPTER 3 Measuring Revenues and Expenses THINKING BEYOND THE QUESTION How do we know how much profit our business has earned? Revenues earned over several fiscal periods usually are allocated to each of the periods involved. Some reasonable basis of allocation is required. Usually, an attempt is made to allocate the revenues in proportion to the amount of activity that occurred each period. Activity may be measured by estimating how much of the total service has been provided each peri- od or by how much of the total cost associated with providing the service has been incurred each period. In some cases, revenues are earned each period, and an equal portion of the revenues is allocated to each fiscal period. For example, revenue associated with leasing a facility to a cus- tomer usually is allocated proportionately to each period of the lease un- der the assumption that the value of services provided is the same each period. QUESTIONS Q3-1 The flow of cash often predates or follows the economic event to which it is related. If financial reports are supposed to measure the economic activities that occurred during a period, the amount of cash that flowed will often not yield useful measurements. For example, a tenant may pay his rent for six months in advance. To recognize six months’ worth of rent revenue in the period the cash was received will overstate the significance of the economic events occurring then. Similarly, if goods are sold in the current accounting period but the cash will not be received until a subsequent period, cash basis accounting will understate the economic significance of sales activities during the current period. Q3-2 Agree. While the accrual measurement of revenue and expense is traced to the accounting period in which the economic event occurred, the cash from that same event might flow in an earlier period, in the same period, or in a later period. Over time, however, the total amount of cash flow is equal to the accrual measure. In fact, the accrual measure is based on the amount of cash that is ultimately expected to flow from the event. 51 52 Chapter 3 Q3-3 Profitability is reported on the income statement using an accrual measure. It is the difference between revenues earned and expenses consumed. Profit is the amount of cash that is ultimately expected to result after all transactions are complete. In the meantime, however, there could be a severe shortage of cash. For example, sales could be made and recorded on the accrual basis even though the related cash is not scheduled for collection until well into the future. Similarly, certain expenses such as insurance, rent, or advertising could be paid for well in advance of their being used. As a result of these events, net income would be high but cash flow would be very low, or perhaps negative. When a company cannot pay its bills on time it can be forced into bankruptcy and dissolution....
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This note was uploaded on 02/04/2012 for the course ACC 500 taught by Professor Santry during the Fall '11 term at Saint Joseph's University.

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IngramSM03rev - CHAPTER 3 Measuring Revenues and Expenses...

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