Principles of Accounting: Chapter Three

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Chapter Summary

Chapter 3 begins by differentiating between concepts of economic and accounting income. Accounting income is largely driven by the measurement of transactions and events, and assigning them to the correct accounting time periods. This gives rise to a set of general principles for revenue and expense recognition. These principles are at the heart of income measurement and accrual-basis accounting.

Following the conceptual explanation of income measurement, the chapter illustrates how this is put into practice via numerous specific examples. These examples show how revenue and expense recognition principles may necessitate end-of-period accounting adjustments. Don't just memorize the examples; engage in a conceptual understanding of when, why, and how adjustments are needed to align accounting measurements with the broader goals of assessing business performance.

The chapter concludes by comparing the accrual basis and cash basis of accounting. Generally accepted accounting principles (GAAP) dictate the accrual basis, but many small businesses may nonetheless find it more cost-effective to utilize the much simpler cash basis.

To aid in your understanding of this chapter, exercises with solutions are available for free download at Bookboon.com. You will find these exercises very helpful in providing models and guidelines for solving all of the problems at principlesofaccounting.com.

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Objectives: Chapter Three

The following learning objectives for this chapter map to the curriculum design for our online university-level courses. These courses are offered through Utah State University, and result in the awarding of up to 6 hours of highly transferrable college credit. To learn more, check out the classroom link.

"Measurement triggering" transactions and events.

Distinguish between the economic and accounting concepts of income.

Why do accountants use the transactions approach to compute net income?

Distinguish between exchange transactions and nonexchange events.

The periodicity assumption and its accounting implications.

Define the periodicity assumption, and know its importance in income measurement.

What is a fiscal year versus a calendar year?

Basic elements of revenue recognition.

Know the meaning of the word "recognize."

Be able to recite the basic conditions precedent to revenue recognition.

Have a basic awareness of extended SEC guidelines for revenue recognition.

Basic elements of expense recognition.

What are the three general rules, with examples of each, for expense recognition?

Understand the importance of the matching principle to expense recognition and income measurement.

Distinguish between payment and recognition.

The adjusting process and related entries.

Why are adjusting entries needed?

Understand and be able to prepare adjusting entries for multiperiod costs and revenues and accrued revenues and expenses.

Know when adjustments are needed.

Define the term "accrual."

Distinguish between a trial balance and an adjusted trial balance.

Be able to deal with the alternative treatment of prepaid expenses and unearned revenues.

Why might the alternative treatment of adjustments "simplify" the accounting process?

Accrual versus cash-basis accounting.

Define and apply both the accrual basis and cash basis of accounting.

Which method of accounting (cash or accrual) is generally preferred, and why?

What is the nature of the modified cash-basis system?

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