Chapter 3 Measuring Business Income Skyline College.

Chapter 3

Measuring Business Income

Skyline College

Copyright © Houghton Mifflin Company. All rights reserved. 3–2

Why Must a Business Be Profitable?

To succeed To survive To increase

stockholders’ equityTo demonstrate

positive performance

Accountants use the term net income when referring to profitability

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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)

Not all increases in stockholders’ equity arise from revenues (Example: Issue stock)

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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, net losses)



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?


ContinuityGoing 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

Assigns revenue and expenses to a specific time period

Time periods are of equal length

The 12-month accounting period is called a fiscal year (does not have to correspond with the calendar year)

Monthly or quarterly periods are called interim periods



What Is Accrual Accounting?Revenues and expenses are recorded in the periods in which they occur regardless 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


Revenue Recognition IllustratedTreadle Website Design, Inc. designs a website for a customer under a predetermined agreement and bills for the service. The customer understands the price and there is a reasonable expectation that the customer will pay the bill.

Should Treadle recognize the revenue when it bills the customer?

Because all four conditions have been met, Treadle should recognize the revenue by debiting Accounts Receivable and crediting Design Revenue.


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



Expense Recognition IllustratedTreadle Website Design, Inc. receives its utility bill for the period.

Should Treadle recognize the expense when it receives the bill?

Treadle has obviously entered into an agreement to pay for utility services as used. Because the expense has been incurred and has helped produce revenue, it should be recorded by debiting Utilities Expense and crediting Accounts Payable.



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


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 one balance sheet account and one income statement account

Necessary to measure profitability

Affect profitability comparisons from one period to the next



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 © Royalty Free C Squared Studios/ Getty Images


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, Treadle Website Design paid two months’ rent in advance, $3,200. The amount was recorded in the Prepaid Rent account.


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

Treadle Website Design 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 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


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, Treadle Website Design received $1,400 as an advance payment for designs to be prepared for a client. By the end of the month, $800 of the design was 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, Treadle Website Design 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


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


Overview of the Accounting Cycle


The Closing Process: Which Accounts Are Closed?

Are closed at the end of each period so the accounts can start counting the next period’s activity

Revenue and expense accounts and the Dividends account

Temporary accounts

accounts begin each period with a zero balance

Balance sheet accounts

Permanent 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 © Royalty Free C Squared Studios/ Getty Images


The Closing Process

Expense Accounts Revenue Accounts

Income Summary

Retained EarningsDividends

xxx

xx

Step 1: Close revenue accounts

xxxxxx

Step 2: Close expense accounts

xx

Step 3: Close Income Summary

xxStep 4: Close

Dividendsaccount

Balance

_ +Balance

_

xxx

+_

+Balance

+Balance

_

xx+

_


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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Chapter 3 Measuring Business Income Skyline College.

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