1. Lecture 4 Income Statement: Cash versus Accrual Accounting

2. Firm of the Day 2

3. Goals of Today’s Class Better understanding of Revenues and Expenses Better understanding of the Income Statement Better understanding of cash versus accrual accounting

4. 4 +- Asset (Debit)(Credit) Liability or Owners’ Equity (Debit)(Credit) +- Retained Earnings Expenses/Losses (Debit) Revenues/Gains (Credit) + + Review: Debits and Credits Memorize this for AssetsFlip it for Liabs + OE An increase in an Expense is a decrease in Retained Earnings. (We decrease Owners’ Equity accounts with a debit.) An increase in a Revenue is an increase in Retained Earnings. (We increase Owners’ Equity accounts with a credit.) Remember RE is an Owners’ Equity Account

5. Review of Shareholders’ Equity What is “contributed capital”? – The initial investment of owners – e.g., common stock What is “retained earnings”? – The cumulative net income of the company that has not been distributed as dividends.

6. Peeking Ahead -- Contributed Capital: Common Stock Accounting for initial public issuance of common stock Very simple if stock has no par value 1. Debit Cash for the amount of the contribution 2. Credit Common Stock for the amount of the contribution Example: Sell 2,000 shares of “no par common” for $8 per share (Debit) Cash $16,000 (Credit) Common Stock $16,000

7. Accounting for initial public issuance of common stock More complicated if stock has a stated par value 1. Debit Cash for the amount of the contribution 2. Credit Common Stock for par value only Example: Sell 2,000 shares of “$1 par common” for $8 per share (Debit) Cash $16,000 (Credit) Common Stock (2,000 shs. @ $1 par) $2,000 3. Credit Other Paid in Capital for the difference (contribution – par value) (Credit) Other Paid in Capital $14,000 Peeking Ahead -- Contributed Capital: Common Stock

8. Balance Sheet Equation A t = L t + SE t A t = L t + CS t + APIC t + RE t A t-1 = L t-1 + CS t-1 + APIC t-1 + RE t-1 (A t - A t-1 ) = (L t - L t-1 ) + (CS t - CS t-1 ) + ( APIC t - APIC t-1 ) + ( RE t - RE t-1 ) ∆A = ∆L + ∆CS + ∆APIC + ∆RE ∆A = ∆L + ∆CS + ∆APIC + Net Income - Dividends ∆A = ∆L + ∆CS + ∆APIC + Revenue - Expenses - Dividends

9. Income Statement Reports Net Income earned by the business over a period of time as a result of its profit-directed activities. Changes in shareholders’ equity due to profit-directed activities during an accounting period. Income statement accounts are temporary accounts. Net Income = Revenues – Expenses

10. Accrual Accounting Goal is to account for all transactions that economically occurred in the pd. To document fundamental economics, we employ the accrual method The accrual method is best contrasted with the cash method of accounting through an example: On December 29 th, Best Buy sells and delivers an HDTV worth $2,000 Customer purchases the TV using 6 month financing Best Buy prepares its income statement and balance sheet on December 31 st (this assumes a December fiscal year end) Did the sale officially occur in the period even though no cash was received? Cash basis: No. Accrual Basis: Yes.

11. Accrual Accounting (continued) To properly account for periodic income, recognize revenues when earned and expenses when incurred, even though no cash has been exchanged This concept is sometimes called the “matching principle”, where revenues are matched with expenses in the period in which they are incurred e.g., salaries are often not paid to employees until a week or two after employees have provided their services At the end of a period, firms must recognize earned, yet still unpaid, salary expense to correctly match the expense to the period in which the services were actually used To allow for proper accounting of revenues and expenses, we employ two temporary holding accounts called Receivables and Payables When revenues are earned, but no cash is received, we record an increase to a Receivable to reflect cash that we are owed in the future When expenses are incurred, but no cash is paid, we record an increase to a Payable to reflect cash that we owe in the future

12. When and how do we identify and measure revenues and expenses? Timing 1.Cash Basis REVENUES with the increase in cash resulting from the sale of goods or services, and EXPENSES with the decrease in cash associated with sales activities. Period 1Period 2Period 3Period 4 Purchase inventory for resale, on credit, Cost = $10 Pay supplier $10 Sell and deliver inventory on credit, Price = $20 Collect $20 from customer

13. Calculating Net Income using Cash Basis Accounting Period 1Period 2Period 3Period 4 Purchase inventory for resale, on credit, Cost = $10 Pay supplier $10 Sell and deliver inventory on credit, Price = $20 Collect $20 from customer Net Income=Revenues-Expenses =Assets in-Assets out Period 1=- Period 2=- Period 3=- Period 4=- 0 -10 0 +20 0 0 0 0 0 10 20 0

14. What is the downside to Cash Basis Accounting? Reflects the cost and benefit of operating transactions only when cash payments and cash receipts occur: - Delay in recognizing revenues until cash is received, despite the fact that the store has performed its primary mission: sale of inventory. - Poor matching of the true costs of generating revenues to the periods in which they are generated.

15. 2. Accrual Basis - Revenues Revenues and expenses are not necessarily associated with the cash inflows and cash outflows. Identification: Revenue is the increase in assets (not necessarily cash) and/or decrease in liabilities resulting from the principal income generating activities of the business -- selling goods or services in the ordinary course of business.

16. Timing (Recognition): Revenues: Benefits earned by an entity when the following criteria are satisfied: 1.The entity has delivered its goods/services to the customer. 2.There is persuasive evidence of an arrangement for customer payment. 3.The price is fixed or determinable. 4.Collection of cash (or other benefits) is reasonably assured, though there may still be some uncertainty (uncollectible accounts, warranties). The degree of uncollectability should be estimated with reasonable reliability. Revenue is recorded according to the revenue principles, regardless of when cash is received!

17. 2. Accrual Basis - Expenses Revenues and expenses are not necessarily associated with the cash inflows and cash outflows. Identification Expense is a decrease in assets (not necessarily cash) and/or an increase in liabilities, in a period, for the purpose of generating revenue in the period

18. Timing (matching) Expenses are recognized – When the associated revenue is recognized – Matched to the timing of revenue – Reported in the income statement in the same period as the revenue they gave rise to. “Matching principle”: recognize costs and/or assets used as expenses in the period in which they produce revenue Goal of accrual accounting: report inflows of assets when they are earned, and net them against outflows of assets used to generate them

19. Calculating Net Income using Accrual Basis Accounting Period 1Period 2Period 3Period 4 Purchase inventory for resale, on credit, Cost = $10 Pay supplier $10 Sell and deliver inventory on credit, Price = $20 Collect $20 from customer Net Income=Revenues-Expenses =Assets in-Assets out Period 1=- Period 2=- Period 3=- Period 4=- 0 0 10 0 0 0 20 0 0 0 0 10

20. Cash vs. Accrual basis of accounting: Summary Cash basis of accounting: Method of accounting where income is calculated by recording revenues when cash is received and expenses when expenditures occur Accrual basis of accounting: Method of accounting where income is calculated by recording revenues when benefits are earned and expenses when resources are given up to produce the revenues (expenses are matched to revenues)

21. Please note that… The aggregate net income over the life of the business is the same for accrual and cash basis accounting, and is equal to cash inflows minus cash outflows. The only difference is one of timing. Cash basis – recognition of revenues and expenses are associated with the cash flows of the period. Accrual basis – timing of cash flows is not necessarily associated with the recognition of revenues and expenses. – Cash may be received/paid before, during, or after revenue and expense recognition.

22. ABC Corp pays $12,000 to prepay 1 year’s rent (Debit) Prepaid Rent $12,000 (Credit) Cash $12,000 Active vs. Passive Journal Entries Generally, two types of journal entries Active: generated by an actual transaction on the transaction date Passive: generated by an end-of-period required adjustment to update an account for a change due to passage of time 1 month elapses. ABC Corp must adjust the Prepaid Rent account to reflect time passage. (Debit) Rent Expense $1,000 (Credit) Prepaid Rent $1,000 Notice the difference: Active transactions are those made by the firm in the conduct of business Passive transactions are those made to update the status or balance of accounts that typically were created previously by active transactions

23. ABC Corp pays $12,000 to prepay 1 year’s rent (Debit) Prepaid Rent $12,000 (Credit) Cash $12,000 Active vs. Passive Journal Entries (continued) If we did not make passive or adjusting entries, our accounts would stay stuck on the original entry and would therefore be inaccurate Prepaid Rent 12,000 Without an adjustment as time passes, this amount would stay here (and on the balance sheet) forever

24. ABC Corp pays $12,000 to prepay 1 year’s rent (Debit) Prepaid Rent $12,000 (Credit) Cash $12,000 Active vs. Passive Journal Entries (continued) If we did not make passive or adjusting entries, our accounts would stay stuck on the original entry and would therefore be inaccurate Prepaid Rent 12,000 1 month elapses. ABC Corp must adjust the Prepaid Rent account to reflect time passage. (Debit) Rent Expense $1,000 (Credit) Prepaid Rent $1,000 1,000 11,000 So at regular time intervals, we make necessary passive adjustments

25. Active vs. Passive Journal Entries (continued) Typical passive entries include adjustments for: Interest owed but not yet paid Rent owed but not yet paid Salaries earned but not yet paid Interest earned but not yet received Rent earned but not yet received Systematic depreciation of assets through time Systematic use or expiration of assets through time (like prepaid rent or drilling rights)

26. Basic Accounting Flow Example Self-Smart Corp receives $100,000 cash from owners to start the business (Debit) Cash $100,000 (Credit) Contributed Capital $100,000 Balance Sheet Accounts Income Statement Accounts 100,000 CashContrib Cap Self-Smart Corp buys one inventory item for $20,000 cash Inventory 20,000 (Debit) Inventory $20,000 (Credit) Cash $20,000 Self-Smart Corp sells the inventory item for $40,000 cash (Debit) Cash $40,000 (Credit) Sales Revenue $40,000 40,000 Sales Revenue(Debit) Cost of Goods Sold (Expense) $20,000 (Credit) Inventory $20,000 Cost of Goods Sold 20,000 End of Period—Prepare Financial Statements

27. Basic Accounting Flow Example Balance Sheet Accounts Income Statement Accounts 100,000 CashContrib Cap Inventory 20,000 40,000 Sales RevenueCost of Goods Sold 20,000 Income Statement Revenues Expenses Net Income  = 40,000 20,000

28. Retained Earns 20,00040,000 Basic Accounting Flow Example Balance Sheet Accounts Income Statement Accounts 100,000 CashContrib Cap Inventory 20,000 40,000 Sales RevenueCost of Goods Sold 20,000 Balance Sheet 120,000 0 20,000 Assets Cash 120,000 Liabilities 0 Owners’ Equity Contrib Cap 100,000 Ret Earns 20,000 Inv 0 100,000 20,000 0 0 40,000

29. An Extended Example

30. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common (Debit) Cash $100,000 (Credit) Common Stock $100,000 100,000 Jan 1: Received $100,000 in exchange for 10,000 shares of common stock

31. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common No journal entry since there was no actual transaction (no services performed by new employee yet) 100,000 Jan 1: Hired warehouse/marketing supervisor at salary of $2,000 per month (paid on 7 th of each month after actual work month has elapsed)

32. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common (Debit) Prepaid Rent $4,500 (Credit) Cash $4,500 100,000 Prepaid Rent 4,500 Jan 1: Prepaid $4,500 to landlord for 3 months rent on warehouse

33. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common (Debit) Inventory $55,000 (Credit) Accounts Payable $55,000 100,000 Prepaid Rent 4,500 Inventory Accts Paybl 55,000 Jan 10: Purchased $55,000 (10,000 units) of inventory on credit. 1% discount if paid within 10 days

34. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common (Debit) Accounts Payable $55,000 (Credit) Cash $54,450 (Credit) Gain on Discount $550 100,000 Prepaid Rent 4,500 Inventory Accts Paybl 55,000 54,450 Discount 550 Jan 19: Paid $54,450 to inventory vendor

35. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common (Debit) Accounts Receivable $26,000 (Credit) Sales Revenue $26,000 100,000 Prepaid Rent 4,500 Inventory Accts Paybl 55,000 54,450 Discount 550 (Debit) Cost of Goods Sold $11,000 (Credit) Inventory$11,000 Accts Recvbl COGS Sales 26,000 11,000 Jan 22: Sold 2,000 units of inventory on credit for $26,000. Collect 2% penalty if not paid in 15 days

36. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent 4,500 Inventory Accts Paybl 55,000 54,450 Discount 550 Accts Recvbl COGS Sales 26,000 11,000 Jan 30: We are done with active January entries. Now we need to passively adjust some accounts before we prepare the January balance sheet and income statement.

37. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent 4,500 Inventory Accts Paybl 55,000 54,450 Discount 550 Accts Recvbl COGS Sales 26,000 11,000 Jan 30: Passive adjustment to reflect prepaid rent that has been used up (Debit) Rent Expense $1,500 (Credit) Prepaid Rent $1,500 1,500 Rent Exp 1,500

38. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent 4,500 Inventory Accts Paybl 55,000 54,450 Discount 550 Accts Recvbl COGS Sales 26,000 11,000 Jan 30: Passive adjustment to reflect the liability you now owe your employee for the work performed 1,500 Rent Exp 1,500 (Debit) Salary Expense $2,000 (Credit) Salary Payable $2,000 Sal Exp Sal Paybl 2,000

39. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent 4,500 Inventory Accts Paybl 55,000 54,450 Discount 550 Accts Recvbl COGS Sales 26,000 11,000 Jan 30: Now we can prepare the financial statements 1,500 Rent Exp 1,500 Sal Exp Sal Paybl 2,000 41,050 3,000 44,000 0

40. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 550 Accts Recvbl COGS Sales 26,000 11,000 Jan 30: Now we can prepare the financial statements Rent Exp 1,500 Sal Exp Sal Paybl 2,000 41,0503,000 44,000 0

41. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 550 Accts Recvbl COGS Sales 26,000 11,000 Jan 30: Now we can prepare the financial statements Rent Exp 1,500 Sal Exp Sal Paybl 2,000 41,0503,000 44,000 0 Sales26,000 Gain from Discount550+ 26,550Total Revenues and Gains  Cost of Goods Sold11,000  Rent Expense1,500  Salary Expense 2,000   Net Income12,050 Income Statement

42. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 550 Accts Recvbl COGS Sales 26,000 11,000 Jan 30: Now we can prepare the financial statements Rent Exp 1,500 Sal Exp Sal Paybl 2,000 41,0503,000 44,000 0 Ret Earns After the income statement is prepared, we transfer Income Statement accounts into Retained Earnings to allow for balance sheet preparation

43. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 550 Accts Recvbl COGS Sales 26,000 11,000 Rent Exp 1,500 Sal Exp Sal Paybl 2,000 41,0503,000 44,000 0 Ret Earns (Debit) Sales $26,000 (Debit) Discount $550 (Credit) Retained Earnings 26,550 Jan 30: Close Revenue Accounts into Retained Earnings 26,000 550 26,550 00

44. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 11,000 Rent Exp 1,500 Sal Exp Sal Paybl 2,000 41,0503,000 44,000 0 Ret Earns (Debit) Retained Earnings $14,500 (Credit) Cost of Goods Sold $11,000 (Credit) Salary Expense $ 2,000 (Credit) Rent Expense $ 1,500 Jan 30: Close Expense Accounts into Retained Earnings 26,550 11,0001,500 2,000 14,500 000 12,050

45. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns Jan 30: Now the Balance Sheet is effectively already prepared 12,050 Total Liabs + Equity = $114,050Total Assets = $114,050

46. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns Jan 30: Now the Balance Sheet is effectively already prepared 12,050 Balance Sheet Assets Cash41,050 Prep Rent3,000 Inventory44,000 Accts Rec26,000 Total Assets114,050 Liabilities + Owners’ Equity Accts Pay0 Salaries Pay2,000 Common Stock100,000 Retained Earns12,050 Total Liabs + OE114,050

47. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 February: Now we continue to build off of these accounts as the business continues February: Notice the Income Statement accounts are all “clean” to enable a new cumulation period

48. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 February 3: Sold 3,000 units of inventory for $39,000 cash (Debit) Cash $39,000 (Credit) Sales Revenue $39,000 (Debit) Cost of Goods Sold $16,500 (Credit) Inventory$16,500 39,000 16,500

49. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 February 7: Paid $2,000 cash for radio advertisements (Debit) Advertising Expense $2,000 (Credit) Cash $2,000 39,000 16,500 Adv Exp 2,000

50. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 February 7: Paid $2,000 salary to employee (Debit) Salary Payable $2,000 (Credit) Cash $2,000 39,000 16,500 Adv Exp 2,000

51. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 February 13: Received payment of $26,520 from Jan 22 nd customer (Debit) Cash $26,520 (Credit) Accounts Receivable $26,000 (Credit) Collected Fee Revenue $520 39,000 16,500 Adv Exp 2,000 26,520 26,000 Fee Rev 520 2,000

52. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 39,000 16,500 Adv Exp 2,000 26,520 26,000 Fee Rev 520 2,000 Feb 29: We are done with active February entries. Now we need to passively adjust some accounts before we prepare the February balance sheet and income statement.

53. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 39,000 16,500 Adv Exp 2,000 26,520 26,000 Fee Rev 520 2,000 Feb 29: Passive adjustment to reflect prepaid rent that has been used up (Debit) Rent Expense $1,500 (Credit) Prepaid Rent $1,500 1,500

54. Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 39,000 16,500 Adv Exp 2,000 26,520 26,000 Fee Rev 520 2,000 1,500 Feb 29: Passive adjustment to reflect the liability you now owe your employee for the work performed (Debit) Salary Expense $2,000 (Credit) Salary Payable $2,000 2,000

55. Feb 29: Now we can prepare the financial statements Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 26,000 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 41,0503,000 44,000 0 Ret Earns 12,050 39,000 16,500 Adv Exp 2,000 26,520 26,000 Fee Rev 520 2,000 1,500 2,000 102,570 1,500 27,5000 2,000

56. Feb 29: I’ll leave it up to you to: Balance SheetIncome Statement AssetsLiabilities Equity Revenues/Gains Expenses/Losses Cash Common 100,000 Prepaid Rent Inventory Accts PayblDiscount 0 Accts Recvbl COGS Sales 0 0 0 Rent Exp 0 Sal Exp Sal Paybl 2,000 0 102,5701,500 27,500 0 Ret Earns 12,050 39,000 16,500 Adv Exp 2,000 Fee Rev 520 1,500 2,000 (1) Prepare the Income Statement (2) Close the Revenue and Expense accounts to Ret Earns (3) Prepare the Balance Sheet