3–13–1 Chapter 3 Measuring Business Income

3–23–2 Copyright © 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’ equity To demonstrate positive performance Accountants use the term net income when referring to profitability

3–33–3 Copyright © Cengage Learning. All rights reserved. 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 © Royalty-Free/Corbis

3–43–4 Copyright © Cengage Learning. All rights reserved. Revenues Increases in stockholders’ equity resulting from… selling goods rendering services performing other business activities Cash Received Promise to Pay Received (Accounts Receivable) © Royalty Free Digital Vision/ Getty Images

3–53–5 Copyright © 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

3–63–6 Copyright © Cengage Learning. All rights reserved. Expenses Decreases in stockholders’ equity resulting from the cost of… selling goods rendering services performing other business activities Cost of doing business Salaries Expense Rent Expense Utilities Expense Depreciation of a building Not all decreases in stockholders’ equity arise from expenses (Example: Dividends)

3–73–7 Copyright © Cengage Learning. All rights reserved. Expenses Cost of doing business Salaries Expense Rent Expense Utilities Expense Depreciation 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

3–83–8 Copyright © Cengage Learning. All rights reserved. 3-8 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

3–93–9 Copyright © Cengage Learning. All rights reserved. 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?

3–10 Copyright © Cengage Learning. All rights reserved. Continuity Measuring 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. $

3–11 Copyright © Cengage Learning. All rights reserved 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.

3–12 Copyright © Cengage Learning. All rights reserved 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

3–13 Copyright © Cengage Learning. All rights reserved. Matching Revenues 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…

3–14 Copyright © Cengage Learning. All rights reserved 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.

3–15 Copyright © Cengage Learning. All rights reserved. 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

3–16 Copyright © Cengage Learning. All rights reserved. Assumptions and the Matching Rule

3–17 Copyright © Cengage Learning. All rights reserved. Accrual Accounting © Royalty Free PhotoDisc Collection/ Getty Images

3–18 Copyright © Cengage Learning. All rights reserved. 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

3–19 Copyright © Cengage Learning. All rights reserved. How Do We Determine When Revenue Should Be Recognized? Revenue recognition process The following conditions should be met: persuasive evidence of an arrangement exists delivery has occurred or services have been rendered seller’s price to buyer is fixed or determinable collectibility is reasonably assured

3–20 Copyright © Cengage Learning. All rights reserved. When Should Expenses Be Recognized? Record when these conditions are met: agreement exists to purchase goods or services goods have been delivered or services rendered a price is established or can be determined goods or services have been used to produce revenue © Royalty-Free/Corbis

3–21 Copyright © Cengage Learning. All rights reserved. Adjusting the Accounts Adjustments 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 © Royalty-Free/Corbis

3–22 Copyright © Cengage Learning. All rights reserved. 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 © Royalty Free C Squared Studios/ Getty Images

3–23 Copyright © Cengage Learning. All rights reserved. The Adjustment Process © Royalty-Free/Corbis

3–24 Copyright © Cengage Learning. All rights reserved Four Types of Adjustments Notice that each adjusting entry involves one balance sheet account and one income statement account (Accrued Expenses)(Deferred Expenses) (Accrued Revenues) (Deferred Revenues)

3–25 Copyright © Cengage Learning. All rights reserved. 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

3–26 Copyright © Cengage Learning. All rights reserved. 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 Expenses Depreciation of Plant and Equipment Amount consumed should be transferred from the asset account to an expense account

3–27 Copyright © Cengage Learning. All rights reserved. Prepaid Expenses Expenses 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 © Royalty-Free/Corbis

3–28 Copyright © Cengage Learning. All rights reserved. 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 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.

3–29 Copyright © Cengage Learning. All rights reserved 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.

3–30 Copyright © Cengage Learning. All rights reserved 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.

3–31 Copyright © Cengage Learning. All rights reserved 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.

3–32 Copyright © Cengage Learning. All rights reserved. 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 © Royalty-Free/Corbis

3–33 Copyright © Cengage Learning. All rights reserved. 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 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

3–34 Copyright © Cengage Learning. All rights reserved 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.

3–35 Copyright © Cengage Learning. All rights reserved. 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

3–36 Copyright © Cengage Learning. All rights reserved 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.

3–37 Copyright © Cengage Learning. All rights reserved. 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 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 2,800 July 15 9,600 July Assets= Liabilities +Stockholders’ Equity July 31 Unearned Design Revenue 800 Design Revenue 800 Dr. Cr.

3–38 Copyright © Cengage Learning. All rights reserved. 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 © Royalty-Free/Corbis

3–39 Copyright © Cengage Learning. All rights reserved. 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 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 5,000July 10 2,800 July 16 9,600 July July

3–40 Copyright © Cengage Learning. All rights reserved. Using the Adjusted Trial Balance to Prepare Financial Statements © Royalty Free PhotoDisc Collection/ Getty Images

3–41 Copyright © Cengage Learning. All rights reserved. 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

3–42 Copyright © Cengage Learning. All rights reserved. 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.

3–43 Copyright © Cengage Learning. All rights reserved. Sequence for Preparing Financial Statements

3–44 Copyright © Cengage Learning. All rights reserved. The Accounting Cycle © Royalty Free PhotoDisc Collection/ Getty Images

3–45 Copyright © Cengage Learning. All rights reserved.

3–46 Copyright © Cengage Learning. All rights reserved. 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

3–47 Copyright © Cengage Learning. All rights reserved. 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

3–48 Copyright © Cengage Learning. All rights reserved. The Closing Process Expense AccountsRevenue Accounts Income Summary Retained EarningsDividends xxx xx Step 1: Close revenue accounts xxx Step 2: Close expense accounts xx Step 3: Close Income Summary xxStep 4: Close Dividends account

3–49 Copyright © Cengage Learning. All rights reserved. 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 © PhotoDisc Collection/ Getty Images

3–50 Copyright © Cengage Learning. All rights reserved.