Chapter 3 Measuring Business Income Skyline College Why

Chapter 3 Measuring Business Income Skyline College

Why Must a Business Be Profitable? ü To succeed ü To survive ü To increase stockholders’ equity ü To demonstrate positive performance © Royalty Free C Squared Studios/ Getty Images Accountants use the term net income when referring to profitability Copyright © Houghton Mifflin Company. All rights reserved. 3– 2

Net Income = Revenues – Expenses Net increase in stockholders’ equity resulting from operations Retained Earnings _ + Net income is accumulated here © Royalty-Free/Corbis If expenses exceed revenues, a net loss occurs Copyright © Houghton Mifflin Company. All rights reserved. 3– 3

Revenues Increases in stockholders’ equity resulting from… ü selling goods ü rendering services ü performing other business activities © Royalty Free Digital Vision/ Getty Images Cash Received Promise to Pay Received (Accounts Receivable) Not all increases in stockholders’ equity arise from revenues (Example: Issue stock) Copyright © Houghton Mifflin Company. All rights reserved. 3– 4

Expenses Decreases in stockholders’ equity resulting from the cost of… ü selling goods ü rendering services ü performing other business activities Cost of doing business © Royalty Free C Squared Studios/ ü Salaries Expense Getty Images ü Rent Expense ü Utilities Expense ü Depreciation of a building Not all decreases in stockholders’ equity arise from expenses (Example: Dividends, net losses) Copyright © Houghton Mifflin Company. All rights reserved. 3– 5

What Assumptions Play A Role in Income Measurement? ü Continuity What is the expected life of the business? ü Periodicity Over what period of time are transactions measured? ü Matching Are expenses assigned to the period in which they are used to generate revenue? Copyright © Houghton Mifflin Company. All rights reserved. 3– 6

Continuity 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 $ Copyright © Houghton Mifflin Company. All rights reserved. when it will become an expense. 3– 7

Periodicity ü Assigns revenue and expenses to a specific time period ü Time periods are of equal length ü The 12 -month accounting period is called a fiscal year (does not have to correspond with the calendar year) © Royalty Free C Squared Studios/ Getty Images ü Monthly or quarterly periods are called interim periods Copyright © Houghton Mifflin Company. All rights reserved. 3– 8

What Is Accrual Accounting? Revenues and expenses are recorded in the periods in which they occur regardless when cash is received or paid Accrual accounting is accomplished by: üRecording revenues when earned üRecording expenses when incurred üAdjusting the accounts © Royalty Free C Squared Studios/ Getty Images Copyright © Houghton Mifflin Company. All rights reserved. 3– 9

How Do We Determine When Revenue Should Be Recognized? Revenue recognition process The following conditions should be met: ü persuasive evidence of an arrangement exists ü delivery has occurred or services have been rendered ü seller’s price to buyer is fixed or determinable ü collectibility is reasonably assured Copyright © Houghton Mifflin Company. All rights reserved. 3– 10

Revenue Recognition Illustrated Treadle Website Design, Inc. designs a website for a customer under a predetermined agreement and bills for the service. The customer understands the price and there is a reasonable expectation that the customer will pay the bill. Should Treadle recognize the revenue when it bills the customer? Because all four conditions have been met, Treadle should recognize the revenue by debiting Accounts Receivable and crediting Design Revenue. Copyright © Houghton Mifflin Company. All rights reserved. 3– 11

When Should Expenses Be Recognized? Record when these conditions are met: ü agreement exists to purchase goods or services ü goods have been delivered or services rendered ü a price is established or can be determined ü goods or services have been used to produce revenue Copyright © Houghton Mifflin Company. All rights reserved. © Royalty-Free/Corbis 3– 12

Expense Recognition Illustrated Treadle Website Design, Inc. receives its utility bill for the period. Should Treadle recognize the expense when it receives the bill? © Royalty Free C Squared Studios/ Getty Images Treadle has obviously entered into an agreement to pay for utility services as used. Because the expense has been incurred and has helped produce revenue, it should be recorded by debiting Utilities Expense and crediting Accounts Payable. Copyright © Houghton Mifflin Company. All rights reserved. 3– 13

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 ü Within reasonable range, management has latitude in making estimates ü Choices will affect net income reported If estimates move outside a reasonable range, financial statements become misleading. Copyright © Houghton Mifflin Company. All rights reserved. ü Manipulation of revenues and expenses to achieve a specific outcome – earnings management ü Not illegal, but not the best practice Fraudulent financial reporting 3– 14

Adjusting the Accounts ü Adjustments are needed because accounts need to be updated to the specific day that the accounting period ends ü Some transactions span the cutoff date ü Accounts must contain all amounts applicable to the period Copyright © Houghton Mifflin Company. All rights reserved. © Royalty-Free/Corbis 3– 15

Impact of Adjustments ü Do not affect cash flows because they never involve the Cash account ü Affect one balance sheet account and one income statement account ü Necessary to measure profitability ü Affect profitability comparisons from one period to the next © Royalty Free C Squared Studios/ Getty Images Copyright © Houghton Mifflin Company. All rights reserved. 3– 16

Types of Adjusting Entries Deferral – postponement of 1. Allocating recorded costs recognition of an expense between two or more already paid or of revenue accounting periods received in advance 2. Recognizing unrecorded expenses Accrual – recognition of a 3. Allocating recorded, revenue or expense that has arisen but is unrecorded unearned revenues between two or more accounting periods 4. Recognizing unrecorded, earned revenues Copyright © Houghton Mifflin Company. All rights reserved. 3– 17

Type 1: Allocating Recorded Costs ü Expenditures often benefit more than one period ü When first recorded, they are usually debited to an asset account ü Amount consumed should be transferred from the asset account to an expense account © Royalty Free C Squared Studios/ Getty Images Two common kinds of adjustments Prepaid Expenses Depreciation of Plant and Equipment Copyright © Houghton Mifflin Company. All rights reserved. 3– 18

Prepaid Expenses like rent, insurance, and supplies are often paid in advance ü When initially paid, these expenses are recorded in an asset account ü The expired amount should be transferred to an expense account at the end of the period Copyright © Houghton Mifflin Company. All rights reserved. © Royalty-Free/Corbis 3– 19

Prepaid Rent Adjustment Illustrated On July 3, Treadle Website Design paid two months’ rent in advance, $3, 200. The amount was recorded in the Prepaid Rent account. ü By July 31, half of the prepaid rent has expired and should be treated as an expense Adjustment July 31: Prepaid rent of $1, 600 has expired for July. Adjust account by allocating the amount to the Rent Expense account. Prepaid Rent July 3 3, 200 Bal. 1, 600 July 31 1, 600 The account now reflects the prepaid August amount July 31 Rent Expense Prepaid Rent Copyright © Houghton Mifflin Company. All rights reserved. Rent Expense July 31 1, 600 The account now reflects the July rent expense amount Dr. 1, 600 Cr. 1, 600 3– 20

Type 2: Recognizing Unrecorded Expenses ü Expenses are often incurred in a period, but not yet recorded ü As the expense accumulates, it is said to accrue Common types of unrecorded expenses Interest Taxes Wages Utilities © Royalty-Free/Corbis Copyright © Houghton Mifflin Company. All rights reserved. 3– 21

Wages Adjustment Illustrated Treadle Website Design 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. ü The unrecorded wages for July 29 – 31 are an expense of July even though they will not be paid until August. 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) Wages Payable July 31 Wages Expense 720 July 26 4, 800 Bal. The account now reflects the liability applicable to July 31 Wages Expense Wages Payable Copyright © Houghton Mifflin Company. All rights reserved. 5, 520 The account now reflects the total July wages expense Dr. 720 Cr. 720 3– 22

Type 3: Allocating Recorded, Unearned Revenues ü Revenues can be received before they are earned ü When received in advance, the company has an obligation to deliver goods or perform services When goods are delivered or services are performed, the liability… is converted Copyright © Houghton Mifflin Company. All rights reserved. Unearned revenues are liabilities into a revenue 3– 23

Unearned Revenue Adjustment Illustrated On July 19, Treadle Website Design received $1, 400 as an advance payment for designs to be prepared for a client. By the end of the month, $800 of the design was completed and accepted by the client. When the payment was originally received, it was recorded as a liability. ü $800 of the advance payment has been earned in July Adjustment July 31: Recognize $800 of the unearned revenue as earned in July. Assets = Liabilities + Unearned Design Revenue July 31 800 July 19 1, 400 Bal. 600 The account now reflects a balance that is unearned revenue Stockholders’ Equity Design Revenue July 10 2, 800 July 15 9, 600 July 31 800 The account now reflects the total revenue applicable to July Dr. July 31 Unearned Design Revenue Copyright © Houghton Mifflin Company. All rights reserved. 800 Cr. 800 3– 24

Type 4: Recognizing Unrecorded, Earned Revenues ü Revenues can be earned but not yet recorded ü As the revenue accumulates, it is said to accrue Common types of unrecorded revenues Interest Revenues earned on operations © Royalty-Free/Corbis Copyright © Houghton Mifflin Company. All rights reserved. 3– 25

Unrecorded Revenue Adjustment Illustrated In July, Treadle Website Design agreed to design a website for Marsh Tire Company with the first section operational by July 31. The fee for this section is $400. ü The fee has been earned by the end of the month, but has not been recorded Adjustment July 31: Recognize $400 as revenue earned in July Accounts Receivable July 15 9, 600 July 31 400 Bal. 5, 000 Design Revenues July 22 5, 000 The account now reflects all receivables for July 31 Accounts Receivable Design Revenue Copyright © Houghton Mifflin Company. All rights reserved. July 10 2, 800 July 16 9, 600 July 31 800 July 31 400 The account now reflects the total revenue applicable to July 400 3– 26

Adjusted Trial Balance Record & post adjusting entries ü Some accounts will Prepare have the same adjusted trial balance they had on balance the trial balance ü Others will be different because adjusting entries changed the balances © Royalty Free C Squared Studios/ Getty Images Copyright © Houghton Mifflin Company. All rights reserved. 3– 27

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. © Royalty Free C Squared Studios/ Getty Images 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. Copyright © Houghton Mifflin Company. All rights reserved. 3– 28

Sequence for Preparing Financial Statements Copyright © Houghton Mifflin Company. All rights reserved. 3– 29

Overview of the Accounting Cycle Copyright © Houghton Mifflin Company. All rights reserved. 3– 30

The Closing Process: Which Accounts Are Closed? Permanent accounts carry their endof-period balances to next period Temporary accounts begin each period with a zero balance Balance sheet accounts Revenue and expense accounts and the Dividends account Copyright © Houghton Mifflin Company. All rights reserved. Are closed at the end of each period so the accounts can start counting the next period’s activity 3– 31

Closing Entries ü Set the stage for the next period by clearing revenue and expense accounts and the Dividends accounts of their balances ü Required at the end of any period for which financial statements are prepared ü Summarize a period’s revenues and expenses by transferring their balances to the Income Summary account Income Summary Account © Royalty Free C Squared Studios/ Getty Images § 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 Copyright © Houghton Mifflin Company. All rights reserved. 3– 32

The Closing Process Expense Accounts Revenue Accounts _ _ + Balance xxx Step 2: Close expense accounts Income Summary _ xxx + + Balance Step 1: Close revenue accounts xxx Balance Step 3: Close Income Summary xx Dividends + _ xx Retained Earnings _ + Step 4: xx xx Balance Close Dividends account Copyright © Houghton Mifflin Company. All rights reserved. 3– 33

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 © Photo. Disc Collection/ Getty Images Copyright © Houghton Mifflin Company. All rights reserved. 3– 34