1 Accounting Systems ELS Preparing an Income Statement

2 Time Period Assumption... Divides the economic life of a business into artificial time periods WHY? to provide immediate feedback on how the business is doing.

3 Time Period Assumption... Generally a month, a quarter, or a year. An accounting time period that starts on January 1 and ends December 31 is called a calendar year. An accounting time period that is one year long is called fiscal year.

4 Revenue Recognition Principle... zdictates that revenue be recognized in the accounting period in which it is earned. zis considered earned ywhen the service has been provided or y when the goods are delivered.

5 Matching Principle... requires that expenses be recorded in the same period in which the revenues they helped produce are recorded.

6

7 Cash Basis Revenue recorded only when cash is received. Expense recorded only when cash is paid.

8 Cash Basis in not GAAP GAAP

9 Accrual Basis Accounting Adheres to the: Revenue Recognition Principle Matching Principle

10 Accrual Basis Accounting Revenue recorded only when earned, not when cash is received Expense recorded only when incurred, not when cash paid

11 Accrual Basis adheres to... Generally Accepted Accounting Principles

12 Year 1 Year 2 Purchased paint, painted building, paid employees Received payment for work done in year one Activity Accrual basis Cash basis Revenue $80,000 Expense 50,000 Net Income $30,000 Revenue $ 0 Expense 50,000 Net Loss ( $50,000) Revenue $80,000 Expense 0 Net Income $80,000 Revenue $ 0 Expense 0 Net Income $ 0

13 Adjusting Entries Adjusting entries make the: z revenue recognition & z matching principles HAPPEN!

14 Types of Adjusting Entries yPrepayments : xPrepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. xUnearned Revenues: Cash received and recorded as liabilities before revenue is earned. yAccruals : xAccrued revenues: Revenues earned but not yet received in cash or recorded. xAccrued expenses: Expenses incurred but not yet paid in cash or recorded.

15 Prepayments Cash or other asset has been spent but the item acquired has not been used or consumed Cash has been collected before revenue is earned

16 You can start with the trial balance to find information to adjust prepayments.

17 Sierra Corporation Trial Balance October 31, 2004 Debit Credit Cash $15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 $28,700 $28,700

18 On October 5 the company paid $2,500 for advertising supplies. GENERAL JOURNAL Debit Credit Oct 5 Supplies 2,500 Cash 2,500 Purchased advertising supplies Supplies 2,500Oct 5 Cash 2,500Oct 5 Supplies Expense Supplies Illustration 4-6

19 An inventory on October 31 reveals that $1,000 of supplies remain on hand; therefore $1,500 of supplies have been used. ($2,500 - $1,000) =$ 1,500 GENERAL JOURNAL Debit Credit Oct 5 Supplies Expense 1,500 Supplies 1,500 To record advertising supplies consumed Supplies 2,500 Oct 5 Cash 2,500Oct 5 Supplies Expense Supplies 1,500Oct 311,500Oct 31 Illustration 4-6

20 Oct $1,500 Mar $1,435 Apr $1,510 May $1,592 Feb $1,601 Nov $1,800 Dec $1,410 Jan $1,425 June $1,652 July $1,621 Aug $1,427 Sept $1,555 Supplies expense is based on usage... so different amounts appear each month Supplies Expense

21 Prepaid Expenses On October 1 the company paid $600 for a 1-year insurance policy. Coverage began October 1. GENERAL JOURNAL Debit Credit Oct 1 Prepaid Insurance 600 Cash 600 Purchased one-year policy effective October 1 Prepaid Insurance 600Oct 1 Cash 600Oct 1 Insurance Expense

22 Insurance Policy 1 Year $ 600 Oct $50 Mar $50 Apr $50 May $50 Feb $50 Nov $50 Dec $50 Jan $50 June $50 July $50 Aug $50 Sept $50

23 Prepaid Expenses On October 31st, $50 ($600/12 months) of the insurance was used-up or expired. GENERAL JOURNAL Debit Credit Oct 31 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month Prepaid Insurance 600Oct 1 Cash 600Oct 1 Insurance Expense 50 Oct 3150 Oct 31

24 How do you apply the Matching Principle to the cost of a long lived asset ? Depreciation

25 Allocate the cost of an asset to expense over its useful life Depreciation is an ALLOCATION CONCEPT- not a VALUATION CONCEPT. We’re not attempting to reflect the actual change in value of an asset! Depreciation

26 Office Equipment Depreciation= $480/year Oct $40 Mar $40 Apr $40 May $40 Feb $40 Nov $40 Dec $40 Jan $40 June $40 July $40 Aug $40 Sept $40

27 GENERAL JOURNAL Debit Credit Oct 31 Depreciation Expense 40 Accumulated Depreciation-Office Equip 40 To record monthly depreciation Accumulated depreciation is a contra asset account - an offset against the fixed asset account. Accumulated Depreciation- Office Equipment 40Oct 31 Office Equipment 5,000Oct 2 Depreciation Expense 40 Oct 31

28 Office equipment$ 5,000 Less : accumulated depreciation 40 $4,960 Balance Sheet Presentation Book Value or Carrying Value

29 Unearned Revenues Received on Oct. 2 $1,200 for advertising services expected to be completed by Dec 31. Unearned Service Revenue Cash 1,200Oct 2 1,200Oct 2 Service Revenue GENERAL JOURNAL Debit Credit Oct 2 Cash 1,200 Unearned Service Revenue 1,200 Collected money for work to be performed by Dec 31.

30 Unearned Revenues During October $400 of the revenue was earned. Unearned Service Revenue Cash 1,200Oct 2 Service Revenue 1,200Oct 2 GENERAL JOURNAL Debit Credit Oct 31 Unearned Service Revenue 400 Service Revenue 400 To record revenue earned Oct

31 Accrual Revenue has been earned, but not collected. Expenses have been incurred, but not yet paid.

32 Accrued Revenues Revenues earned but not yet received in cash or recorded at the statement date

33 Accrued Revenues Earned $200 for advertising services to clients in October, but they were not billed until after October 31st. GENERAL JOURNAL Debit Credit Oct 31 Accounts Receivable 200 Service Revenue 200 Accounts Receivable 200Oct 31 Service Revenue 200Oct 31

34 Accrued Expenses Expenses incurred but not yet paid or recorded at the statement date.

35 Formula for Computing Interest Face Value of NoteInterest Time in term of One Year Annual Interest Rate $ 5,000 X 12% 1/12 =$50 Interest expense is the cost a company incurs to use money: Information needed to compute interest expense: face value of note interest rate (always expressed in annual rate) the length of time note is outstanding

36 Interest ExpenseInterest Payable Oct GENERAL JOURNAL Debit Credit Oct 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month Accrued Interest

37 Accrued Salaries - Salaries Paid for after the Service Has Been Performed.

38 Salaries ExpenseSalaries Payable Oct 31 1,200 GENERAL JOURNAL Debit Credit Oct 31 Salaries Expense 1,200 Salaries Payable 1,200 Accrue salary expense for the month Accrued Salaries

39 The adjusted trial balance is used to prove the equity of total debit balances and total credit balances after the adjusting entries have been made. Financial statements can be easily prepared from the adjusted trial balance. Adjusted Trial Balance

40 SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Retained Earnings Statement For the Month Ended October 31, 2004 SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004

41 Balance as Oct. 31 from Retained Earnings Statement SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Balance Sheet October 31, 2004

42 Closing the Books Closing entries transfer the temporary account balances to the stockholders’ equity account... and reduce the balances in the temporary accounts to zero.

43 Temporary Permanent All revenues accountsAll asset accounts All expense accountsAll liability accounts Dividends Stockholders’ equity accounts

44 Retained Earnings is a permanent account; the others shown here are temporary Individual Expenses Retained Earnings Income Summary Individual Revenues Dividends

45 The Accounting Cycle

46 Required Steps in the Accounting Cycle zAnalyze business transactions. zJournalize the transactions. zPost to ledger accounts. zPrepare a trial balance. zJournalize and post adjusting entries-- prepayments and accruals. zPrepare an adjusting trial balance.

47 Page 202 in book Sales Revenue Cost of Goods Sold Gross Profit Operating Expenses Net Income (Loss) Less Equals How Income is Measured in a Merchandising Company

48 What Is Charged to Merchandise Inventory? zAll costs of getting the inventory to company and ready to sell y+Freight-In y+Special Permits zOnly costs associated with merchandise purchased for resale - not assets acquired for use, such as supplies

49 Merchandise Purchases On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc. Task:Record the purchase by getting information from the Purchase Invoice. The Purchase Invoice is a copy of the sales invoice.

50 1. Seller 2.Invoice Date 3.Purchaser 4.Salesperson 5.Credit terms 6.Freight terms 7.Goods sold: catalog no.,description, quantity, price per unit 8.Total invoice price Invoice No. 731 Address 125 Main Street Attention o f James Hoover, Purchasing Agent Firm Name: Sauk Stero City Chelsea State Illinois Zip Date5/4/04 Salesperson Maone Terms 2/10,n/30 Freight Paid by Buyer Catalog No. Description QTY Price Amount IMPORTANT : ALL RETURNS MUST BE MADE WITHIN 10 DAYS TOTAL $3,800 1, Production Model Circuits A2547Z48

51 Merchandise Purchases On May 4 the company bought $ 3,800 worth of merchandise from PW Audio Supply, Inc. GENERAL JOURNAL Debit Credit May 4 Merchandise Inventory 3,800 Accounts Payable 3,800 To record goods purchased on account. Accounts Payable Merchandise Inventory May 4 3,800 Freight-out May 4 3,800

52 Purchases Returns and Allowances On May 8 the company returned $300 worth of merchandise to PW Audio Supply, Inc. GENERAL JOURNAL Debit Credit May 8 Accounts Payable 300 Merchandise Inventory 300 To record goods returned that were purchased on account. Accounts Payable Merchandise Inventory May 4 3,800 Freight-out May 4 3,800May 8 300

53 Freight Costs - On Incoming Inventory

54 Freight Costs - On Incoming Inventory On May 6 the company paid $ 150 to have the merchandise inventory delivered to them. GENERAL JOURNAL Debit Credit May 6 Merchandise Inventory 150 Cash 150 To record payment of freight. Freight-Out Merchandise Inventory May 4 3,800 Cash May 6 150May May 6 150

55 Freight Costs - On Outgoing Inventory

56 Freight Costs-on outgoing inventory On May 6 the seller company paid $ 150 to have merchandise inventory delivered to the buyer. GENERAL JOURNAL Debit Credit May 6 Freight-Out 150 Cash 150 To record payment of freight on goods sold. Freight-Out Merchandise Inventory Cash May 6 150

57 Purchase Discounts Credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. Credit terms specify the amount of cash discounts and the time period during which they are offered. 2/10,n/30 1/10 EOM

58 Purchases Discounts Review - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was paid within the discount period Original Invoice $3,800 -Returns 300 Amount due before discount $3,500 2% discount 70 Net due $3,430

59 Purchases Discounts Review - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was paid within the discount period. GENERAL JOURNAL Debit Credit May 14 Accounts Payable 3,500 Cash 3,430 Merchandise Inventory 70 To record payment within discount period. Accounts Payable Merchandise Inventory May 4 3,800 Cash May 4 3,800May May May 14 3,500 May May 6 150

60 Payment of Invoice Review - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was NOT paid within the discount period. GENERAL JOURNAL Debit Credit June 3 Accounts Payable 3,500 Cash 3,500 To record payment NOT within discount period. Accounts Payable Merchandise Inventory May 4 3,800 Cash May 4 3,800May Jun 3 3,500

61 Sales Invoice... a business document that provides written evidence of a credit sale.

62 1. Seller 2.Invoice Date 3.Purchaser 4.Salesperson 5.Credit terms 6.Freight terms 7.Goods sold: catalog no.,description, quantity, price per unit 8.Total invoice price Invoice No. 731 Address 125 Main Street Attention o f James Hoover, Purchasing Agent Firm Name: Sauk Stero City Chelsea State Illinois Zip Date 5/4/04 Salesperson Maone Terms 2/10,n/30 Freight Paid by Buyer Catalog No. Description QTY Price Amount IMPORTANT : ALL RETURNS MUST BE MADE WITHIN 10 DAYS TOTAL $3,800 1, Production Model Circuits A2547Z48

63 Sales Revenues - Under a Perpetual System zare recorded when earned-revenue recognition principle zmust be supported by a business document- written evidence z2 entries are made for each sale yone to record sale yone to record cost of merchandise sold

64 Sales - under a perpetual system Assume a sale of $ 3,800 ON ACCOUNT Cash Accounts Receivable Merchandise Inventory Cost of Goods Sold Sales Returns & Allowances Sales May 4 3,800 May 4 2,400 For merchandise having a cost of $2,400 May 4 3,800

65 Sales Returns and Allowances Flip side of purchase returns and allowance On buyer’s books GENERAL JOURNAL Debit Credit May 8 Accounts Payable 300 Merchandise Inventory 300 To record goods returned that were purchased on account. On seller’s books GENERAL JOURNAL Debit Credit May 8 Sales Returns and Allowance 300 Accounts Receivable 300 To record return of goods delivered to Sauk Stero.

66 Sales - under a perpetual system Assume a sale of $ 3,800 ON ACCOUNT Cash Accounts Receivable Merchandise Inventory Cost of Goods Sold Sales Returns & Allowances Sales May 4 3,800 May 4 2,400 For merchandise having a cost of $2,400 May 4 3,800

67 What Is the Sales Returns and Allowances Account? zContra Revenue Account to sales zUsed to show how much came in on returns and allowances Excessive returns and allowances suggest: zinferior merchandise zinefficiencies in filing orders zerrors in billing customers zmistakes in delivery or shipment of goods

68 What Is the Sales Discount Account? zContra Revenue Account to sales zUsed to disclose amount of cash discounts taken by customers

69 Sales Discounts Flip side of purchase discounts On seller’s books GENERAL JOURNAL Debit Credit May 14Cash 3,430 Sales Discounts 70 Accounts Receivable 3500 To record collection within discount period. On buyer’s books GENERAL JOURNAL Debit Credit May 14 Accounts Payable 3,500 Cash 3,430 Merchandise Inventory 70 To record payment within discount period

70 Two Forms Of Income Statements zSingle-step income statement  Multiple-step income statement

71 Single-Step Income Statement One step… subtract total expenses from total revenues Revenues $10,000 Expenses 3,000 Net income$ 7,000

72 PW AUDIO, Inc. Single-step Income Statement For the Year Ended December 31, 2004 Sales $460,000 Interest Revenue 3,000 Gain on Sale of equipment 600 Total Revenues$463,600 Expenses Cost of goods sold$316,000 Selling expenses 76,000 Administrative expenses 38,000 Interest expense 1,800 Casualty Loss from vandalism 200 Income tax expense 10,100 Total expenses 442,100 Net income $ 21,500

73 Sales revenues Sales$ 480,000 Less: Sales returns and allowance$12,000 Sales discounts 8,000 20,000 Net sales 460,000 Cost of goods sold 316,000 Gross profit $ 144,000Operating expenses Selling expenses: Store salaries expense $45,000 Advertising expense 16,000 Depreciation expense 8,000 Freight-out 7,000 Total selling expenses$76,000 Administrative expenses Salaries expense $19,000 Utilities expense 17,000 Insurance Expense 2,000 Total administrative expenses 38,000 Total operating expenses114,000 Income from operations $ 30,000 PW AUDIO SUPPLY, INC. Multi-step Income Statement For the Year Ended December 31, 2004

74 Income from operations (continued) $ 30,000 Other revenues and gains Interest revenue $ 3,000 Gain on sale of equipment 600 $ 3,600 Other expenses and losses Interest expense $ 1,800 Casualty loss from vandalism 200 2,000 1,600 31,600 Income before income taxes Income tax expense 10,100 Net income $21,500 PW AUDIO SUPPLY, INC. Multi-step Income Statement For the Year Ended December 31, 2004

75 Cost of Goods Sold - Periodic Method A running account of changes in inventory is not maintained. Separate accounts use to record freight costs, returns and discounts Cost of goods sold and ending inventory are calculated at end of period.

76 Cost of goods sold Inventory, January 1$ 36,000 Purchases$325,000 Less Purchase returns and allowances $10,400 Purchase discounts 6,800 17,200 Net purchases 307,800 Add: Freight-in 12,200 Cost of goods purchased 320,000 Cost of goods available for sale 356,000 Inventory, December 31 40,000 Cost of goods sold 316,000 PW AUDIO SUPPLY, INC. Cost of Goods Sold For the Year Ended December 31, 2004