measuring business income (with adjusting & closing

MEASURING BUSINESS INCOME (With Adjusting & closing Entries)

• ADJUSTING ENTRIES: End-of-period entries that assign the financial effects of implicit transactions to the appropriate time periods.

Features of Adjusting Entries

1. Every adjusting entry affects both a balance sheet account (i.e. asset or liability) and an Income Statement (i.e. revenue or expense).

2. Adjusting entries never affect the cash account since adjustments are needed when transactions affect the revenue or expenses of more than one accounting period.

Transactions result in Deferrals

• Deferrals: It is a delay of the recognition of expenditure or revenue already received – Concerned with past cash receipts and payments.

• Expl: Prepaid Expenses & unearned revenue.

Transactions result in Accruals

• Accruals: Recognition of an expense that has not been paid or of revenue that has not been received – Concerned with future cash receipts and payments.

• Expl.: Salaries of employees neither billed nor paid.

Types of Adjusting Entries1. PREPAID EXPENSES

• Recorded costs to be apportioned among two or more accounting periods.

• By the end of the period, the portion of these services that has been consumed during the period has become an expense and the unused portion represents an asset

PREPAID EXPENSES…….

• Expl.: Inventory, prepaid expenses etc.

• Insurance protection, originally recorded as prepaid insurance for Rs.7,200 of which Rs.3,000 becomes an expense for the current period.

• Analysis:Increase in Insurance expense and decrease in prepaid expense.

PREPAID EXPENSES…….

• Rule: Increase in expense is recorded by a debit and decrease in asset is recorded by a credit.

• Insurance Expense Prepaid Insurance

3,000 7,200 3,000

2. Unrecorded / Accrued / Outstanding Expenses

• These expenses were incurred during the period, but no record of them has yet been made (Expense Payable).

• Expl.: RS.5,000 of wages earned by an employee during the period, but not yet paid to the employee.

• Analysis: Increase in Wage Expense & Increase in the liability of Accrued/ Outstanding Wages.

Unrecorded / Accrued / Outstanding Expenses……….

• Rule: Increase in expense has to be debited& Increase in liability has to be created.

• Wages Expense Accrued Wages

5,000 5,000

3. Unearned Revenue/ Revenue Received in Advances

• Recorded revenues to be apportioned among two or more accounting periods.

• These amounts were initially recorded in one account, and at the end of the accounting period must be properly divided between a revenue and a liability account.

Unearned Revenue………

• Expl.: Rent collected during the period and recorded as rent revenue – Rs.7,500 of which, Rs.6,000 is applicable to the next period and hence is a liability at the end of the current period.

• Analysis: Liability (Unearned rent revenue) decreased. Revenues (Rent revenue earned) increased.

Unearned Revenue………

• Rule: Decrease in liability is recorded by a debit and increase in revenue is recorded by a credit.

• Rent Rev. Earned Unearned Rent Rev

1,500 1,500 7,500

4. UNRECORDED/ACCRUED REVENUES

• These revenues were earned during the period but no record of them has yet been made.

• Expl.:Rs.1,200 of interest earned by the entity during the period but not yet received.

• Analysis: Increase in asset (Interest Receivable) and increase in revenue (Interest Revenue).

ACCRUED REVENUES………

• Rule: Increase in asset is recorded by a debit and increase in revenue is recorded by a credit.

• Interest Receivable Interest Revenue

1,200 1,200

5. Depreciation

• Portion of long-lived asset costs that has become expense during an accounting period.

• Factors: 1.Service life of asset, 2. Residual Value, 3. Cost of the asset along with additional maintenance expenses.

Depreciation Methods

1. Straight Line Method (SLM)Original Cost – Estimated Scrap

Estimated useful life (Amount of Depreciation is fixed)2. Written Down Value Method 1 - n Estimated Scrap Value Original Cost (Depreciation Rate is fixed)

Depreciation Methods

• Sum of the Year Digit method (SYD)• Rate of Depreciation =

(n/SYD) = for the first year{(n-1)/SYD} = for the second year

{(n-2)/SYD} = for the third year• SYD = 1+2+3+……….+n• Rate is applied to the net cost.

Example

• A Construction company purchased an earthmoving equipment for Rs.20,00,000, expected to have an useful life of 6 years, or 15,000 hours with an estimated residual value of Rs.2,00,000 at the end of the time. The equipment logged 2,000 hours in the first year.

• Compute depreciation expenses under various methods.

Amortization

• Business acquires intangible assets viz. patents, copyright, trademark, goodwill by paying large sums of money – Unexpired cost.

• Expiration of these costs (similar to depreciation) is known as Amortization.

• Amortization is always on straight line basis.• Intangible assets are amortized over a

reasonably short period (as it is difficult to determine the useful life precisely).

Accounting Treatment of Depreciation

1. Amount of depreciation is debited to Depreciation Expense.

2. A separate account called ‘Accumulated Depreciation’ is credited for the amount allocated to the period instead of making a direct credit to the asset account.

3. The ‘Accumulated Depreciation’ is a contra asset account (this is reported as a deduction from related asset account in the balance sheet.

Example

• Rs.3,500 is the depreciation expense for furniture.

• Analysis: Depreciation expense increased, concerned asset decreased through accumulated depreciation.

• Entry: Increase in expense is recorded by a debit and decrease in asset is recorded by a credit to contra-asset account – accumulated Depreciation, concerned asset.

Example………

• Depn. Expense Acc.Depn.,Furniture 3,500 3,500

• Depreciation is recorded in the Income Statement as expense.

• Furniture will be shown in the B/S as: Furniture………….. 35,000 Less, Accumulated Depn… 3,500 31,500

Reasons………

• GAAP requires separate disclosure of:

1. Original cost of entity’s depreciable assets;

1. Depreciation that has been accumulated on these assets from the time they were required until the date of Balance sheet.

6. BAD DEBTS

• Arises because of credit sales.• Such a state initially is recorded as: Debit

Accounts Receivable, Credit Sales Revenue.• But when bad debts occur, another entry must

be made to show that:• Amount debited to A/R does not represent the

amount of the additional asset and that O.E. has not in fact increased by the amount of sale.

Accounting Treatment

1. Direct Write-Off Method: Amounts that are believed to be bad are subtracted from A/R and same accounts are shown as expenses in Income Statement.

• Entry: Debit Bad Debt Expense Credit Accounts Receivable

• This method, however, requires that specific uncollectible accounts be identified, which is not usually possible.

Accounting Treatment………

2. Allowance Method: Here, the total amount of uncollectible accounts is first estimated to be shown under ‘Bad Debts Expense A/c’ in the Income statement.

• Then, the estimate is shown as a Contra Asset in the B/S in the form of ‘Allowance for Doubtful Debts Account’.

• Entry: Debit Bad Debts Expense

Credit Allowance for Doubtful Debts A/C

Accounting Treatment………

• Bad Debts Exp. Allow. for Doubtful Debt

300 300

• In the Balance sheet:

Accounts Receivable-10,000

Less, Allow. for Doubtful Debts- 300

Accounts Receivable Net - 9,700

Accounting Treatment………

• Now, if a company decides a specific customer is never going to pay the amount owed, then:

• Entry: Debit Allowance for doubtful debts…50 Credit Accounts Receivable ………..50

• This entry does not have any effect on Bad Debt Expense or on income of the period in which account is written off.

7. SALES DISCOUNT………

• Cash discounts to induce the customers pay quickly.

• Expl.: ‘2/10, net 30’- permits customers to deduct 2% from the invoice amount if the amount is paid within 10 days, or the full amount is due within 30 days.

Recorded in three ways:

1. Can be recorded as a reduction from gross sales;

2. Can be recorded as ‘expense’ of the period;

3. Sales revenue can be initially recorded at the net amount after deducting discount.

Amount received from customers who do not take discount would then be recorded as additional revenue.

Thus, for Rs.1,000 sale subject to a 2% cash discount, the entry can be:

• Debit Accounts Receivable……..980

Credit Sales Revenue…………...980

• If the customer does not take discount, then entry upon receipt of payment is:

Debit Cash……………………….1,000

Credit Discount Not Taken…………20

Credit Accounts Receivable………980

ACCOUNTING CYCLE

1. Financial data collected from invoices, sales memoranda, cheque, cash book etc. are analyzed & journalized.

2. Posted to General Ledger to determine the effect of basic accounting equation.

3. Trial balance is prepared at the end of the accounting period.

4. Passing adjusting entries for final statements – Adjusted trial balance is prepared.

ACCOUNTING CYCLE……

5. From adjusted trial balance, 3 primary financial statements are prepared.

6. Revenue & expenses accounts are closed and Net Income/ Net Loss is transferred to Retained Earnings A/c.

7. A post-closing trial balance is prepared in order to see that accounting records are in balance ready to start accounting process in the next accounting period.

Steps in formation of accounting records

• Identify transactions• Analyze & record them in journals• Ledger posting• Trial Balance• Preparing Adjusting entries• Worksheet• Income Summary & Balance sheet• Transfer entries

Completion of Accounting cycle

• After identifying the adjustments, accountants accommodate them through Work Sheet.

• Proforma Worksheet• Accounts Trial balance Adjustments Adjusted TB P&L A/c B/S

Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.

Steps to prepare Worksheet

1. Enter the A/c balances in Trial balance column, in adjustments column & in Adjusted Trial balance column.

2. Enter each account in the Adjusted T.B. column to either P&L or B/S column.

3. Total P&L A/c and B/S columns & enter the Net profit or loss as a balancing figure in both pairs of columns. Total the four columns with the balancing figure included.

PREPARING FINANCIAL STATEMENTS

1. After preparing the work sheet, the adjusting entries must be entered in the general journal & posted to the ledger accounts.

2. Next, closing entries should be designed to transfer the balances in revenue and expenses accounts to P&L account.

3. Balancing P&L A/c to identify Net profit or loss for the accounting period.

CLOSING ENTRIES

• Journal entries designed to transfer the balances in revenue and expense accounts at the end of an accounting period to a balance sheet equity account.

• Temporary accounts are closed now by transferring their balances to Income Summary or Profit & Loss account.

• Permanent accounts are also closed to extract their balances to prepare B/S.

Closing Revenue & Expenses(Temporary Accounts)

1. Transferring Revenue Accounts

Debit All revenue accounts

Credit Profit & Loss A/c or Income Summary

2. Transferring Expenses Accounts

Debit Profit & Loss A/c or Income Summary

Credit All expenses accounts

Closing Revenue & Expenses(Temporary Accounts)…….

3. Balance of Profit & Loss a/c transferred to Retained Earnings or Profit & Loss Appropriation Account.

(i) If net profit:

Debit Profit & Loss Account

Credit Retained Earnings Account

(ii) If net loss:

Reverse entry

Closing Revenue & Expenses(Temporary Accounts)………

4. Closing Dividend Account ( Having Debit Balance)

Debit Retained Earnings Account

Credit Dividend Account

5. Now all temporary accounts relating to revenue expenses, dividend have zero balance & ready to be used for next accounting period.

Accounts after closing

• All temporary accounts have now zero balances & balances of permanent accounts are carried forward to next period.

• Post-Closing Trial Balance: Accuracy check for all permanent accounts and temporary accounts to be reflected in the balance sheet.

Reversing Entries

• A reversing entry is the exact reverse of the adjusting entry for accruals (Accrued Expenses & Revenues) to which it relates.

• The amounts and the accounts are same, the debits and credits are just reversed.

• Adjusting entries for deferrals viz. prepaid expenses & unearned revenue are not to be reversed.