Measuring Business Income 3

Profitability Measurement: Issues and Ethics OBJECTIVE 1: Define net income, and explain the assumptions underlying income measurement and their ethical application.

Figure 1: Assumptions and the Matching Rule

Profitability Measurement: Issues and Ethics Net income is the excess of revenues over expenses; net loss is the reverse. Revenues are increases in owner’s equity resulting from selling goods, rendering services, or performing other business activities.

Profitability Measurement: Issues and Ethics Expenses are the decreases in stockholders’ equity resulting from the cost of selling goods or rendering services in the course of earning revenue. The continuity assumption states that when measuring income, in the absence of evidence to the contrary, the accountant should assume that a business will continue to operate indefinitely.

Profitability Measurement: Issues and Ethics The periodicity issue recognizes that the measurement of net income for a given period is at best an estimate. A fiscal year is any 12-month period; it may or may not correspond to the calendar year.

Profitability Measurement: Issues and Ethics Under the cash basis of accounting, revenues and expenses are recognized (recorded) when cash is received or paid.

Profitability Measurement: Issues and Ethics According to the matching rule, revenues are recorded in the accounting period in which they are earned, and expenses are recorded in the same accounting period as the revenue generated by the particular expense; the timing of cash receipts and payments is irrelevant.

Profitability Measurement: Issues and Ethics Earnings management is the manipulation of revenues and expenses to achieve a specific outcome. While not illegal within small ranges, larger variations can mislead the user and lead to fraudulent financial reporting.

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Accrual Accounting OBJECTIVE 2: Define accrual accounting, and explain how it is accomplished.

Exhibit 1: Trial Balance

Accrual Accounting Accrual accounting consists of all the techniques used to apply the matching rule. –When a revenue is recorded before cash is received, a receivable is also recorded. –When an expense is recorded before cash is paid, a payable is also recorded.

Accrual Accounting Accrual accounting consists of all the techniques used to apply the matching rule. –Adjusting entries are required when (1) recorded costs have to be allocated between two or more accounting periods, (2) unrecorded expenses exist, (3) recorded unearned revenues must be allocated between two or more accounting periods, and (4) unrecorded revenues exist.

Accrual Accounting Determining when revenue is earned is known as revenue recognition.

Accrual Accounting The SEC stated that all the following conditions must exist before revenue is recognized: –Persuasive evidence of an arrangement exists. –A product or service has been delivered. –The seller’s price to the buyer is fixed or determinable. –Collectibility is reasonably assured.

Accrual Accounting Adjusting entries ensure that transactions appear in the proper accounting period. Adjusting entries do not affect cash flow because they never involve the Cash account, but they are important for the accurate measure of performance.

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The Adjustment Process OBJECTIVE 3: Identify four situations that require adjusting entries, and illustrate typical adjusting entries.

Figure 2: The Four Types of Adjustments

Figure 3: Adjustment for Prepaid (Deferred) Expenses

Figure 4: Adjustment for Unrecorded (Accrued) Expenses

Figure 5: Adjustment for Unearned (Deferred) Revenues

Figure 6: Adjustment for Unrecorded (Accrued) Revenues

The Adjustment Process Adjusting entries are made at the end of the period. –A deferral is the postponement of the recognition of revenue received in advance or of an expense already paid (cash has already changed hands). Allocate recorded costs between two or more accounting periods. Allocate recorded, unearned revenues between two or more accounting periods.

The Adjustment Process Adjusting entries are made at the end of the period. (cont.) –An accrual is the recognition of a revenue or expense that has arisen but has not yet been recorded (cash has not yet changed hands). Recognize unrecorded expenses. Recognize unrecorded, earned revenues.

The Adjustment Process Prepaid rent and prepaid insurance are transferred (at least in part) to expense accounts.

The Adjustment Process Office supplies used are recorded as Office Supplies Expense. Usually an inventory of office supplies is taken to calculate the cost of supplies used.

The Adjustment Process Depreciation on buildings and equipment must be recorded. –Depreciation is the logical allocation of asset cost to the accounting periods benefited. –Depreciation Expense is a temporary account used to record depreciation during a given accounting period. Accumulated Depreciation is a permanent account that shows the total depreciation recorded in all prior periods. –Show the balance sheet presentation of the Accumulated Depreciation account.

The Adjustment Process

Accrued expenses (expenses incurred but not paid) are recorded. Examples are accrued interest, wages, and taxes. Unearned revenues (liabilities) are transferred (at least in part) to earned revenues. Accrued revenues (revenues earned but not received) are recorded.

The Adjustment Process

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Using the Adjusting Trial Balance to Prepare Financial Statements OBJECTIVE 4: Prepare financial statements from an adjusted trial balance.

Exhibit 2: Relationship of the Adjusted Trial Balance to the Income Statement

Exhibit 3: Relationship of the Adjusted Trial Balance to the Balance Sheet and Statement of Retained Earnings

Using the Adjusting Trial Balance to Prepare Financial Statements An adjusted trial balance is prepared after all the adjusting entries have been posted to the ledger. Once the adjusted trial balance is in balance, the financial statements can be prepared.

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The Accounting Cycle OBJECTIVE 5: Describe the accounting cycle, and explain the purpose of closing entries.

Exhibit 7: Overview of the Accounting Cycle

Exhibit 8: Overview of the Closing Process*

The Accounting Cycle Closing Entries –Balance Sheet accounts are permanent accounts because they carry their end-of-period balances into the next period. –Revenue and expense accounts are temporary accounts because they begin each accounting period with a zero balance.

The Accounting Cycle Closing Entries –Closing entries are made at the end of each period and serve two purposes Clear revenue and expense accounts Summarize a period’s revenue and expenses in the Income Summary account

The Accounting Cycle The Post-Closing Trial Balance –Determines that all temporary accounts have zero balances –Double-checks that total debits equal total credits –This final trial balance contains only balance sheet accounts because the income statement accounts and the Dividends account have all been closed and now have zero balances.

Cash Flows from Accrual-Based Information OBJECTIVE 6: Use accrual-based information to analyze cash flows.

Cash Flows from Accrual-Based Information Accrual-based net income indicates whether management has met its profitability goal. Cash flow measures liquidity. Cash paid (received) equals maximum possible cash payments (or receipts) minus cash not paid (or received) this period.

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