Principles of Financial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © by Houghton Mifflin Company. All rights reserved.

Chapter 3 Measuring Business Income

Copyright © by Houghton Mifflin Company. All rights reserved. LEARNING OBJECTIVES Define net income and its two major components, revenues and expenses. Explain the difficulties of income measurement caused by the accounting period issue, the continuity issue, and the matching issue. Define accrual accounting and explain two broad ways of accomplishing it. Copyright © by Houghton Mifflin Company. All rights reserved.

LEARNING OBJECTIVES (continued) State four principal situations that require adjusting entries. Prepare typical adjusting entries. Prepare financial statements from an adjusted trial balance. Copyright © by Houghton Mifflin Company. All rights reserved.

Supplemental Objective Analyze cash flows from accrual-based information. Copyright © by Houghton Mifflin Company. All rights reserved.

Profitability Measurement: The Role of Business Income OBJECTIVE 1 Define net income and its two major components, revenues and expenses. Copyright © by Houghton Mifflin Company. All rights reserved.

Profitability Measurement: The Role of Business Income Profitability and liquidity are the two major goals of a business. To succeed, a business must earn a profit. Profit, as a word, may be ambiguous. Net income is the preferred term. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Net Income Net income is the net increase in owner equity that results from the operations of a company. Net Income = Revenues - Expenses. Revenue > Expenses, net income. Revenue < Expenses, net loss. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Revenues Revenues are increases in Owners Equity resulting from selling goods, rendering services or performing other business activities. Revenue for a given period equals: Cash + Receivables from goods and services provided. Liabilities are generally not affected by revenues. A bank loan increases liabilities but is not revenue. A collection of accounts receivable increases cash but is not revenue. Owner investments increase Owner’s Equity but are not revenues. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Expenses Expenses are decreases in Owner’s Equity resulting from the costs of selling goods, rendering services, or performing other business activities. Expenses are the costs of doing business. Not all cash payments are expenses. Prepaid expenses are recorded as assets. As they expire, they become expenses. Purchase of plant assets (e.g. equipment) is not an expense. Not all decreases in Owner’s Equity arise from expenses. Owner withdrawals are not expenses. Payment on a liability is not an expense. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. Why does the accountant use the term net income instead of profit? A. Profit has many meanings. Accountants use the term net income to define the net increase in owner equity produced by business operations. Net income equals revenues minus expenses when revenues exceed expenses. Copyright © by Houghton Mifflin Company. All rights reserved.

The Accounting Period Issue OBJECTIVE 2 Explain the difficulties of income measurement caused by the accounting period issue, the continuity issue, and the matching issue. Copyright © by Houghton Mifflin Company. All rights reserved.

The Accounting Period Issue Not all transactions can easily be assigned to a specific time period. The accountant makes an assumption about periodicity. The net income for any period of time less than the life of the business, although tentative, is still a useful estimate of the entity’s profitability for the period. Time periods are usually of equal length for comparability. Copyright © by Houghton Mifflin Company. All rights reserved.

The Measurement of Business Income Financial statements may be prepared for any time period, usually a calendar year. Accounting periods of less than one year are called interim periods. The fiscal year is the twelve-month accounting period used by a company. Can be the same as the calendar year. Can be different from the calendar year as the needs of the business dictate. The time period is noted in the financial statements. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. Why does the need for an accounting period cause problems? A. Any measurement of net income over a short period of time is necessarily tentative, and not all transactions can be easily assigned to specific periods. It is necessary to recognize that the life of the business is a useful approximation of the net income for the period. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. The Continuity Issue The measurement of business income requires that certain expenses and revenues be allocated over several accounting periods. The continuity issue relates to the estimated length of the business entity’s life. The accountant assumes that an entity is a going concern: that the entity will continue indefinitely. If a firm is not a going concern, financial statements may be prepared on the basis of the liquidation value of the assets -- that is, what they will bring in cash. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. What is the significance of the continuity issue? A. The continuity issue, or the going concern issue, states that unless there is evidence to the contrary, a business will continue to operate indefinitely. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. The Matching Issue The cash basis of accounting recognizes revenues when received in cash and expenses when paid in cash. Cash basis accounting has matching problems. To adequately measure net income, revenues and expenses must be assigned to the appropriate accounting period. The matching rule states that: Revenues must be assigned to the accounting period in which the goods are sold or services performed. Expenses must be assigned to the accounting period in which they are used to produce revenue. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. Why must a business recognize warranty expense in the year of the sale rather than in the year of the repair or replacement? A. To measure a business’s performance accurately, each expense must be matched with its related revenue. Otherwise, net income will be overstated and the liability will be understated. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Accrual Accounting OBJECTIVE 3 Define accrual accounting and explain two broad ways of accomplishing it. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Accrual Accounting Accrual accounting “attempts to record the financial effects on an enterprise of transactions and other events and circumstances . . . in the periods in which those transactions, events, and circumstances occur rather than only in the periods in which cash is received or paid by the enterprise.” Accrual accounting is an application of the matching rule. Copyright © by Houghton Mifflin Company. All rights reserved.

Implementation of Accrual Accounting Accrual accounting is done in two ways. 1. By recording revenues when earned and expenses when incurred. When a sale is made on credit, revenue is recorded in the Accounts Receivable account before the cash is received. When an expense is incurred on credit, an expense is recorded in the Accounts Payable account before the cash is paid. Revenue recognition: determining when revenue should be recorded. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. 2. By adjusting the accounts. Those transactions that span the cutoff period must be allocated to the proper accounting period. Example: A prepayment of 6 months’ office rent must be adjusted on a monthly basis if accurate monthly financial statements are to be prepared. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. In what two ways is accrual accounting accomplished? A. Accrual accounting is accomplished by (1) recording revenues when earned and expenses when incurred, and (2) making end-of-period adjustments to revenue and expense accounts. Copyright © by Houghton Mifflin Company. All rights reserved.

Accrual Accounting and Performance Measures Adjustments do not affect cash flows in the current period. Adjustments affect profitability comparisons from one period to the next. Assets and liabilities are also affected, providing information about liquidity. Judgment is required to make many adjusting entries. Errors can lead to misleading performance measures. Copyright © by Houghton Mifflin Company. All rights reserved.

The Adjustment Process OBJECTIVE 4 State four principal situations that require adjusting entries. Copyright © by Houghton Mifflin Company. All rights reserved.

The Adjustment Process Adjusting entries are used to apply accrual accounting to transactions that span more than one accounting period. Adjusting entries involve at least one balance sheet account and at least one income statement account. Adjusting entries never involve the Cash account. Copyright © by Houghton Mifflin Company. All rights reserved.

Four Types of Adjusting Entries Costs have been recorded that must be allocated between two or more accounting periods. Expenses have been incurred but are not yet recorded. Unearned Revenues have been recorded that must be allocated between two or more accounting periods. Revenues have been earned but not yet recorded. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Deferrals A deferral is the postponement of: The recognition of an expense already paid (Type 1 adjustment), or A revenue received in advance (Type 3 adjustment). Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Accruals An accrual is the recognition of: A revenue (Type 4 adjustment) or An expense (Type 2 adjustment) that has arisen but has not yet been recorded. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. What do plant and equipment, office supplies, and prepaid insurance have in common? A. They are all assets that must be allocated to expenses over time; this means they all require adjusting entries at the end of the accounting period. Copyright © by Houghton Mifflin Company. All rights reserved.

Allocating Recorded Costs Between Two or More Accounting Periods OBJECTIVE 5 Prepare typical adjusting entries. Copyright © by Houghton Mifflin Company. All rights reserved.

Type 1: Allocating Deferred Expenses Prepaid Expenses: Rent Expense Dr. Cr. Jan. 31 Rent Expense 400 Prepaid Rent 400 Rent Expense Prepaid Rent Jan. 31 400 Jan. 31 400 Jan. 2 800 Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Type 1: Allocating Deferred Expenses Prepaid Expenses: Insurance Expense Dr. Cr. Jan. 31 Insurance Expense 40 Prepaid Insurance 40 Insurance Expense Prepaid Insurance Jan. 8 480 Jan. 31 40 Jan. 31 40 Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Type 1: Allocating Deferred Expenses Prepaid Expenses: Art Supplies Expense Dr. Cr. Jan. 31 Art Supplies Expense 500 Art Supplies 500 Art Supplies Expense Art Supplies Jan. 31 500 Jan. 31 500 Jan. 6 1,800 Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Adjustment for Prepaid (Deferred) Expenses Copyright © by Houghton Mifflin Company. All rights reserved.

Type 1: Allocating Deferred Expenses Prepaid Expenses: Office Supplies Dr. Cr. Jan. 31 Office Supplies Expense 200 Office Supplies 200 Office Supplies Expense Office Supplies Jan. 6 800 Jan. 31 200 Jan. 31 200 Copyright © by Houghton Mifflin Company. All rights reserved.

Type 1: Allocating Deferred Expenses Depreciation of PP&E: Art and Office Equipment Dr. Cr. Jan. 31 Depreciation Expense, Art Eqpt. 70 Accumulated Depreciation, Art Eqpt. 70 Jan. 31 Depreciation Expense, Office Eqpt. 50 Accumulated Depreciation, Office Eqpt. 50 Accumulated Depreciation, Art Equipment Jan. 31 70 Accumulated Depreciation, Office Equipment Jan. 31 50 Depreciation Expense, Art Equipment Depreciation Expense, Office Equipment Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Type 1: Allocating Deferred Expenses Depreciation of PP&E: Office Equipment Dr. Cr. Jan. 31 Depreciation Expense, Office Equipment 50 Accumulated Depreciation, Office Equipment 50 Accumulated Deprn, Office Equipment Jan. 31 50 Depreciation Expense, Office Equipment Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Adjustment for Depreciation Copyright © by Houghton Mifflin Company. All rights reserved.

Accumulated Depreciation – A Contra Account Contra Accounts: A separate account paired with a related account. The Contra Account balance is deducted from the related account. The result is known as the Book Value or Carrying Value. Accumulated depreciation is a contra account used to Recognize that depreciation is an estimate. Show the original cost of the asset, how much of that cost has been allocated as expense, the balance left to be depreciated. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Type 2: Recognizing Unrecorded Expenses Accrued Expenses: Accrued Wages Dr. Cr. Jan. 31 Wages Expense 180 Wages Payable 180 Wages Expense Wages Payable Jan. 31 180 Jan. 31 180 Jan. 26 600 Jan. 12 600 Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Adjustment for Unrecorded (Accrued) Expenses Copyright © by Houghton Mifflin Company. All rights reserved.

Type 3: Allocating Deferred Revenues Deferred Revenues: Unearned Fees Dr. Cr. Jan. 31 Unearned Art Fees 400 Art Fees Earned 400 Art Fees Earned Unearned Art Fees Jan. 31 400 Jan. 31 400 Jan. 15 1,000 Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Adjustment for Unearned (Deferred) Revenues Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Type 4: Recognizing Unrecorded Revenues Accrued Revenues: Advertising Fees Dr. Cr. Jan. 31 Fees Receivable 200 Advertising Fees Earned 200 Advertising Fees Earned Fees Receivable Jan. 31 200 Jan. 31 200 Jan. 26 600 Jan. 12 600 Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Adjustment for Unrecorded (Accrued) Revenues Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. Where does unearned revenue appear on the balance sheet? A. Unearned revenue appears as a liability on the balance sheet. Copyright © by Houghton Mifflin Company. All rights reserved.

Using the Adjusted Trial Balance to Prepare Financial Statements OBJECTIVE 6 Prepare financial statements from an adjusted trial balance. Copyright © by Houghton Mifflin Company. All rights reserved.

The Adjusted Trial Balance (ATB) The ATB is prepared after adjusting entries have been recorded and posted. The ATB is a listing of all accounts and their balances. The ATB should have equal debits and credits. Financial statements are prepared from the ATB by copying the appropriate accounts to the appropriate financial statement. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Discussion Q. Why is the income statement the first statement prepared from the adjusted trial balance? A. The income statement is prepared first because the net income figure is needed to complete the statement of Owner’s Equity. The ending owner’s capital account balance is needed to prepare the balance sheet. Copyright © by Houghton Mifflin Company. All rights reserved.

Cash Flows, Accrual Accounting, and Management Objectives SUPPLEMENTAL OBJECTIVE 7 Analyze cash flows from accrual-based information. Copyright © by Houghton Mifflin Company. All rights reserved.

Cash Flows from Accrual-Based Information Management has a liquidity goal, which is measured by cash flow. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Every revenue or expense account on the income statement usually has one or more related accounts on the balance sheet. Supplies Expense is related to Supplies. Wages Expense is related to Wages Payable. Cash flows generated or paid by company operations may also be determined by analyzing these relationships. Copyright © by Houghton Mifflin Company. All rights reserved.

General Rules for Determining Cash Flow Prepaid Expense Ending Balance + Expense for the Period - Beginning Balance = Cash Payments for Expenses. Unearned Revenue Ending Balance + Revenue for the Period - Beginning Balance = Cash Receipts from Revenues. Copyright © by Houghton Mifflin Company. All rights reserved.

General Rules for Determining Cash Flow (continued…) Accrued Expense Beginning Balance + Expense for the Period - Ending Balance = Cash Payments for Expenses. Accrued Revenue Beginning Balance + Revenue for Period - Ending Balance = Cash Receipts from Revenues. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. Example Computation Prepaid Insurance at June 30 $670 Insurance Expense during June + 120 Potential cash payments for insurance $790 Less Prepaid Insurance at May 31 - 480 Cash payments for insurance during June $310 Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. OKAY, LET’S REVIEW... 1. Define net income and its two major components, revenues and expenses. 2. Explain the difficulties of income measurement caused by the accounting period issue, the continuity issue, and the matching issue. 3. Define accrual accounting and explain two broad ways of accomplishing it. Copyright © by Houghton Mifflin Company. All rights reserved.

Copyright © by Houghton Mifflin Company. All rights reserved. AND FINALLY... 4. State four principal situations that require adjusting entries. 5. Prepare typical adjusting entries. 6. Prepare financial statements from an adjusted trial balance. 7. Analyze cash flows from accrual-based information. Copyright © by Houghton Mifflin Company. All rights reserved.