3–13–1 chapter 3 measuring business income. 3–23–2 copyright © cengage learning. all rights...

3–1

Chapter 3

Measuring Business Income

3–2Copyright © Cengage Learning. All rights reserved.

Why Must a Business Be Profitable?

Profitability is a major goal of a business.

Profit must be attained-To succeed To survive To increase stockholders’ equityTo demonstrate positive performance

Accountants use the term net income when referring to profitability


Net Income

Net Income =

Net increase in stockholders’ equity resulting from operations

Retained Earnings

Net income is accumulated

here

If expenses exceed revenues, a net loss occurs

Revenues – Expenses

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RevenuesIncreases in stockholders’ equity resulting from…

selling goods rendering services performing other business

activities

Cash Received Promise to Pay Received(Accounts Receivable)

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3–5Copyright © Cengage Learning. All rights reserved. 3-5

Not all increases in cash or stockholders’ equity arise from revenues

• Transactions that increase cash and other assets but are not revenues.– A bank loan

• Increases liabilities and cash

– Collection of accounts receivable• Increases cash and decreases accounts receivable

– Revenue was previously recorded when the sale took place

– Investments by Owners


ExpensesDecreases in stockholders’ equity resulting from the cost of… selling goods rendering services performing other business

activities

Cost of doing business

Salaries ExpenseRent ExpenseUtilities ExpenseDepreciation of a building

Not all decreases in stockholders’ equity arise from expenses (Example: Dividends)


Expenses

Cost of doing business

Salaries ExpenseRent ExpenseUtilities ExpenseDepreciation of a building

Not all decreases in stockholders’ equity arise from expenses (Example: Dividends)

Include •Costs of Goods sold•Activities necessary to carry on a business

•Attracting and serving customers


Expenses (cont’d)

• Transactions that decrease cash and other assets but are not expenses.– Cash payments to reduce liabilities

• Decrease cash and decrease a liability– The expense was recorded when the purchase took place

– Cash payments for dividends• Decrease cash and increase Dividends

– Dividends is a stockholders’ equity account, not an expense account


What Assumptions Play A Role in Income Measurement?

Continuity What is the expected life of the business?

Periodicity Over what period of time are transactions measured?

Matching Are expenses assigned to the period in which they are used to generate revenue?


ContinuityMeasuring transactions requires that certain expenses and revenues

be allocated over several accounting periods.

Going Concern Assumption

Unless there is evidence to the contrary, the accountant assumes that the business will continue to operate indefinitely

Balance Sheet The cost of

certain assets may be held until a future

year…

Income Statement

when it will become an expense.

$


Periodicity• Addresses the difficulty of assigning revenues and

expenses to a specific period of time.

• Accountants make an assumption about periodicity:– net income for any period of time less than the life of the

business is a useful estimate of the entity’s profitability for the period.

• Time periods are of equal length to make comparisons easier.

• Financial statements may be prepared for any time period.


Accounting Periods• Fiscal year

– Twelve-month accounting period used by an organization

• Businesses can use the calendar year

• Or, their fiscal year can correspond to the yearly activity of the business cycle

• The fiscal year used should always be noted in the financial statements

• Interim period– Accounting periods of less than one year

• Usually a month or quarter


MatchingRevenues should be assigned to the accounting

period in which the goods are sold or the services performed

Expenses must be assigned to the accounting period in which they are used to produce revenue

Recognize expenses and related revenues in same period

Allocate costs in a systematic way to accounting periods that benefit from the costs

If cause and effect relationship exists…

If no cause and effect relationship exists…


Cash Basis of Accounting• Some businesses use the cash basis of

accounting, though it does not follow the matching rule.– Expenses are recorded when cash is paid.

– Revenues are recorded when cash is received.


Ethical Use of the Matching Rule

Applying the matching rule involves judgment Example: Useful life of equipment is an estimate that should

be realistic and supportable

Within reasonable range, management has latitude in making estimates

Choices will affect net income reported

Manipulation of revenues and expenses to achieve a specific outcome – earnings management

Not illegal, but not the best practice

If estimates move outside a reasonable range, financial statements become misleading.

Fraudulent financial reporting


Assumptions and the Matching Rule


Accrual Accounting

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What Is Accrual Accounting?Revenues and expenses are recorded in the periods in which they occur rather than in the periods when cash is received or paid

Accrual accounting is accomplished by:

Recording revenues when earned

Recording expenses when incurred

Adjusting the accounts


How Do We Determine When Revenue Should Be Recognized?

Revenue recognition process

The following conditions should be met: persuasive evidence of an arrangement existsdelivery has occurred or services have been rendered seller’s price to buyer is fixed or determinable collectibility is reasonably assured


When Should Expenses Be Recognized?

Record when these conditions are met: agreement exists to

purchase goods or servicesgoods have been delivered

or services rendered a price is established or

can be determinedgoods or services have

been used to produce revenue



Adjusting the AccountsAdjustments are needed because accounts

need to be updated to the specific day that the accounting period ends

Some transactions span the cutoff date

Accounts must contain all amounts applicable to the period



Impact of Adjustments Do not affect cash flows because they never involve

the Cash account

Affect assets, liabilities, revenues, and expenses

Necessary to measure profitability

Affect profitability comparisons from one period to the next

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The Adjustment Process



Four Types of Adjustments

Assets Liabilities

Expense

1. Recorded costs are

allocated between two or more accounting periods

2. Expenses are

incurred but not yet recorded

Revenue

4. Revenues are

earned but not yet recorded

3. Recorded unearned

revenues are allocated between two or more accounting periods

INC

OM

E S

TA

TE

ME

NT

BALANCE SHEET

Notice that each adjusting entry involves one balance sheet account

and one income statement account

(Accrued Expenses)(Deferred Expenses)

(Accrued Revenues)(Deferred Revenues)


Types of Adjusting Entries

1. Allocating recorded costs between two or more accounting periods

2. Recognizing unrecorded expenses

3. Allocating recorded, unearned revenues between two or more accounting periods

4. Recognizing unrecorded, earned revenues

Deferral – postponement of

recognition of an expense already paid or of revenue received in advance

Accrual – recognition of a revenue or expense that has arisen but is unrecorded


Type 1: Allocating Recorded Costs

Expenditures often benefit more than one period

When first recorded, they are usually debited to an asset account

Two common kinds of adjustments

Prepaid ExpensesDepreciation of Plant and Equipment

Amount consumed should betransferred from the asset accountto an expense account


Prepaid ExpensesExpenses like rent, insurance, and supplies are often paid in advance

When initially paid, these expenses are recorded in an asset account

The expired amount should be transferred to an expense account at the end of the period



July 3 3,200

Prepaid Rent Adjustment Illustrated

By July 31, half of the prepaid rent has expired and should be treated as an expense

Rent Expense

Adjustment July 31: Prepaid rent of $1,600 has expired for July. Adjust account by allocating the amount to the Rent Expense account.

July 31 1,600 July 31 1,600

Bal. 1,600

The account now reflects the prepaid August amount

The account now reflects the July rent expense amount

Dr. Cr.July 31 Rent Expense 1,600 Prepaid Rent 1,600

Prepaid Rent

On July 3 Miller Design Studio paid two months’ rent in advance, $3,200. The amount was recorded in the Prepaid Rent account.


Depreciation of Plant and Equipment

• When a long-term asset is purchased, the company pays in advance for the usefulness of the asset for as long as it benefits the company.

• This purchase of an asset is a deferral of an expense.

• The cost of the asset must be allocated over its estimated useful life.

• The amount allocated to any one period is called depreciation, or depreciation expense.


Depreciation Expense• Is incurred during an accounting period to

produce revenue

• Must be estimated– The useful life of the asset

• The cost of the asset and its estimated useful life are used to determine the amount expensed each month

– A number of methods exist for determining depreciation

• Depreciation expense does not reduce the asset account directly, but is recorded in a contra account.


Plant Asset Contra Account• A separate account, Accumulated Depreciation, is paired

with the asset account.

• Used to show the accumulated amount of depreciation expensed for the related asset.

• The balance in the contra account is shown on the financial statements as a deduction from the related asset account.

• Contra accounts are used to– Recognize that depreciation is an estimate

– Preserve the original cost of the asset.

• In combination with the asset account, they show– How much of the asset has been allocated as an expense

– The balance left to be depreciated.


Type 2: Recognizing Unrecorded Expenses

Expenses are often incurred in a period, but not yet recorded

Common types of unrecorded expenses

Interest Taxes

Wages Utilities

As the expense accumulates, it is said to accrue



Adjustment July 31: Accrue the unrecorded wages. The secretary earns $2,400 every two weeks. ($2,400/ 10 working days = $240/day x 3 days = $720)

The unrecorded wages for July 29 – 31 are an expense of July even though they will not be paid until August.

Wages Payable

Wages Adjustment Illustrated

Wages Expense

July 31 720

The account now reflects the liability applicable to July

The account now reflects the total July wages expense

Dr. Cr.July 31 Wages Expense 720 Wages Payable 720

July 26 4,800

Miller Design Studio pays its employees every two weeks. The last pay period ended on July 26. The secretary worked July 29 – 31, but will not be paid until the regular payday in August.

Bal. 5,520


Type 2: Estimated Income Taxes

• Miller Design Studio is subject to federal income taxes.– Actual amount owed will not be known until the end

of the year.– Income tax expense for each month is estimated.

• Joan Miller estimates that July’s share of federal income taxes for the year is $800.– Income Taxes Expense is debited for $800 and Income

Taxes Payable is credited for $800.


Type 3: Allocating Recorded, Unearned Revenues

Revenues can be received before they are earned

When received in advance, the company has an obligation to deliver goods or perform services

Unearned revenues are

liabilities

is converted

When goods are delivered or

services are performed, the

liability…

into a revenue


Type 3: Deferred Revenues• The postponement of the recognition of revenues

already received.

• Require allocating recorded unearned revenues between two or more accounting periods.– Recorded unearned revenue

• Revenues that are received in advance (creating a liability)

• Deferred revenues are credited to a liability account.

• At the end of the accounting period the amount that has been earned is transferred to a revenue account.


Adjustment July 31: Recognize $800 of the unearned revenue as earned in July.

$800 of the advance payment has been earned in July

Unearned Design Revenue

Unearned Revenue Adjustment Illustrated

Design Revenue

July 31 800

The account now reflects a balance that is unearned revenue

The account now reflects the total revenue applicable to July

July 19 1,400

On July 19, Miller Design Studio received $1,400 as an advance payment for brochures to be prepared for a client. By the end of the month, $800 of the brochures were completed and accepted by the client. When the payment was originally received, it was recorded as a liability.

Bal. 600

July 10 2,800July 15 9,600

July 31 800

Assets = Liabilities + Stockholders’ Equity

July 31 Unearned Design Revenue 800 Design Revenue 800

Dr. Cr.


Type 4: Recognizing Unrecorded, Earned Revenues

Revenues can be earned but not yet recorded

Common types of unrecorded revenues

Interest Revenues earned on operations

As the revenue accumulates, it is said to accrue



Adjustment July 31: Recognize $400 as revenue earned in July

The fee has been earned by the end of the month, but has not been recorded

Accounts Receivable

Unrecorded Revenue Adjustment Illustrated

Design Revenues

July 31 400

The account now reflects all receivables for July

The account now reflects the total revenue applicable to July

July 31 Accounts Receivable 400 Design Revenue 400

July 15 9,600

In July, Miller Design Studio agreed to design a website for Marsh Tire Company with the first section operational by July 31. The fee for this section is $400.

Bal. 5,000

July 22 5,000 July 10 2,800July 16 9,600

July 31 400July 31 800


Using the Adjusted Trial Balance to Prepare Financial Statements



Adjusted Trial Balance

Record & post adjusting

entries

Prepare adjusted

trial balance

Some accounts will have the same balance they had on the trial balance

Others will be different because adjusting entries changed the balances


Preparing the Financial Statements

1. Use revenue and expense accounts from the adjusted trial balance to prepare the income statement.

2. The statement of retained earnings is prepared using net income or loss from the income statement and dividends from the adjusted trial balance.

3. The resulting balance of retained earnings is used to prepare the balance sheet along with the asset, liability, and any other stockholders’ equity accounts from the adjusted trial balance.


Sequence for Preparing Financial Statements

Income Statement Revenue accounts

– Expense accounts Net income

Balance Sheet Assets Asset accounts Liabilities Liability accounts Stockholders’ Equity Common stock Retained earnings

Statement of Retained Earnings Beginning retained earnings

+ Net Income – Dividends Ending retained earnings

Adjusted Trial Balance Asset accounts Liability accounts Common Stock Retained Earnings Dividends Revenue accounts Expense accounts


The Accounting Cycle



The Closing Process: Which Accounts Are Closed?

Are closed at the end of each period

Revenue and expense accounts and the Dividends account

Temporary accounts, or nominal, accounts begin each period with a zero balance

Are not closed at the end of each period

Balance sheet accounts

Permanent accounts, or real accounts, carry their end-of-period balances to next period


Closing Entries Set the stage for the next

period by clearing revenue and expense accounts and the Dividends accounts of their balances

Required at the end of any period for which financial statements are prepared

Summarize a period’s revenues and expenses by transferring their balances to the Income Summary account

Does not appear on financial statements Only used in the closing process Balance of account equals the net income or net

loss reported on the income statement

Income Summary Account


The Closing ProcessExpense Accounts Revenue Accounts

Income Summary

Retained EarningsDividends

xxxxxx

xx

xx

Step 1: Close revenue accounts

xxxxxx

Step 2: Close expense accounts

xx

Step 3: Close Income Summary

xxStep 4: Close

Dividendsaccount


Still in Balance?

Now that the closing entries have been

posted, are you sure that the ledger

accounts are still in balance?

Prepare a Post-Closing Trial Balance

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3–13–1 chapter 3 measuring business income. 3–23–2 copyright © cengage learning. all rights...

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