Net Income Net income is an increase in

Net Income • Net income is an increase in owner’s equity resulting from the profitable operation of the business • It is calculated in the income statement • Net income is then used in the balance sheet when calculating the owner’s equity • Net Income= Revenues-Expenses

OVERNIGHT AUTO SERVICE Income Statement For the Month Ended December 31, 2001 Revenue: Repair Service Revenue $10, 380 Expenses: Advertising Expense $830 Wages Expense 4900 Supplies Expense 400 Depreciation Expense: Building 150 Depreciation Expense: Tools and Building 200 6480 Net Income $3, 900

Mystery Mountain Lodge Balance Sheet December 31, 2001 Assets Cash Accounts Receivable Land Buildings Furnishings Equipment Snowmobiles 21, 400 10, 600 425, 000 450, 000 58, 700 29, 200 15, 400 Total 1010300 Liabilities& Owners Equity Accounts payable 54, 800 Salaries payable 33, 500 Interest payable 12, 000 Notes payable 620, 000 Total Liabilities 720, 300 Stanley Gardner, Capital 236, 100 Retained earnings 3, 900 Capital Stock 50, 000 Total 1010300

• Income shows the results of business operations over a period of time (e. g. a month, a year) • The period of time covered by an income statement is termed the company’s accounting period • The 12 month accounting period used by an entity is called its fiscal year • Revenue should be recognized at the time goods are sold or services are rendered. This concept is known as the realization principle • In measuring net income for a period, revenue should be offset by all the expense incurred in producing that revenue. This concept is known as the matching principle • The recording of revenue in the period in which it is earned and recording expenses in the period in which they are incurred is the concept of accrual basis of accounting • Expenditures benefiting more than one time period must be allocated over time

Debit and Credit Rules for Revenue and Expenses • Revenue increases owner’s equity, therefore, revenue is recorded by a credit( right side of the T account) • Expenses decrease owner’s equity, therefore, expenses are recorded by a debit( left side of the T account)

Adjusting Entries • Often a transaction affects the revenue or expense of two or more different periods. In these cases, adjusting entries are needed to assign to each period the appropriate amounts of revenue and expenses. These entries “adjust” the balances of various ledger accounts-hence the name, adjusting entries. • Adjusting entries are performed at the end of each accounting period but prior to preparing the financial statements

Adjusting Entry • Example: $9720 worth of supplies was purchased in December. At the time this was recorded as Supplies (asset). On Dec 31 the amount of supplies used must be recorded as an expense. Supplies worth $8670 remain with the company. Adjustment: Dec 31 Supplies Expense 1050 Supplies 1050 To record supplies used

Depreciation • Definition: The systematic allocation of the cost of an asset to expense during the periods of its useful life • Factors relevant in determining depreciation: ▫ Cost: consists of all the necessary and reasonable expenditures to acquire it and to prepare it for intended use ▫ Salvage value: is an estimate of the assets value at the end of its benefit period ▫ Useful life: the length of time it is productively used in a company’s operations

Depreciation- Straight Line Method • Is the most commonly used method. • An equal portion of the assets cost is allocated to depreciation expense in every period of the assets estimated useful life. Depreciation Expense (per period)=Cost of the asset Estimated useful life =$10000 -$1000 5 years = $1800 per year

…Cont Dec 31 Depreciation expense 1800 Accumulated depreciation To record annual depreciation 1800 • The 1800 depreciation expense is reported on the income statement among operating expenses. The 1800 accumulated depreciation is a contra asset account to the Machinery account in the balance sheet.

Adjusting Recorded (Prepaid) Costs Example: $2400 is the cost of 24 months of insurance. This is prepaid in advance. The benefits begin on Dec 1, therefore on Dec 31 we will record the expense for one month. Adjustment: Dec 31 Insurance Expense 100 Prepaid Insurance 100 To record the first month’s expired insurance

Adjusting Unearned Revenue Example: The consulting revenue for the next 2 months amounts to $3000. The payment is made in advance. On Dec 31, 5 days of revenue has been earned by providing the Service. Dec 26 Cash 3, 000 Unearned Consulting Revenue 3, 000 Received advance payment for the next 60 days Adjustment: Dec 31 Unearned Consulting Revenue 250 To record earned revenue that was received in advance($3000*5/60)

Adjusting Unrecorded (Accrued) Expenses • Accrued expenses refer to costs that are incurred in a period but are both unpaid and unrecorded Example: The salary is paid every Monday, however there are three days left in the year which will be unrecorded. Therefore, an adjusting entry must be made. Adjustment: Dec 31 Salaries expense 210 Salaries payable 210 To record three days accrued salary(3*$70)

Adjusting Unrecorded (Accrued) Revenues • Accrued revenues refer to revenues earned in a period that are both unrecorded and not yet received in cash (or other assets). Accrued revenues commonly arise from services, products, interest, and rent. Example: The 30 day service fee is $2700. At Dec 31, 20 days of services have been provided. Since the service has not been completed, the company has neither billed the club yet nor recorded the services already provided. Adjustment Dec 31 Accounts Receivable 1, 800 Consulting Revenue 1, 800 To record 20 days accrued revenue(2700*20/30)

Adjusting Entries and Accounting Principles Adjusting entries are tools by which accountants apply the realization and matching principles Realization principle: • Revenues are recognized when they are earned • Expenses are recognized as the related goods and services are used Matching principle: • Direct association of costs with specific revenue transactions • Systematic allocation of costs over the useful life of the expenditure Concept of Materiality: • The concept of materiality allows accountants to use estimated amounts and even to ignore other accounting principles if these actions will not have a material effect on the financial statements.

Types of Transactions requiring Adjustments Before Adjusting Category Balance Sheet Income Statement Adjusting Entry Prepaid expense Asset overstated Expense understated Dr. Expense Unearned revenues Cr. Asset Liability overstated Revenue understated Accrued expenses Dr. Liability Cr. Revenue Liability understated Expense understated Dr. Expense Cr. Liability Accrued revenues Asset understated Revenue understated Dr. Asset Cr. Revenue

Accounting Cycle 1. 2. 3. 4. 5. 6. 7. 8. Journalize transactions Post to ledger accounts Prepare a trial balance Make end of period adjustments Prepare an adjusted trial balance Prepare financial statements Journalize and post closing entries Prepare an after closing trial balance

Closing the Temporary Equity Accounts • At the end of the period journal entries are made to close the temporary accounts( revenue, expense, and owners drawing accounts) and they are transferred to the owner’s capital account. • These accounts are called temporary accounts because they accumulate the transactions of only one accounting period. • The transfer of these accounts to the capital account has two purposes: ▫ It updates the balance of the owner’s capital account ▫ It returns the balance of the temporary accounts to zero for the next accounting period

Closing Entry for Revenue Accounts • The revenue and expense accounts are closed at the end of each period by transferring their balances to a summary account called Income Summary Dec 31 Repair Service Revenue 10, 380 Income Summary 10, 380 To close the Repair Service Revenue account

Closing Entries for Expense Accounts Dec 31 Income Summary 6, 480 Advertising Expense 830 Wages Expense 4, 900 Supplies Expense 400 Depreciation Expense: Building 150 Depreciation Expense: Tools and Equipment 200 To close the expense accounts

Closing the Income Summary Account and Owner’s Drawing Account Dec 31 Income Summary Michael Mc. Bryan, Capital To close the income summary account for December by transferring the net income to the owner’s capital account 3, 900 Dec 31 Michael Mc. Bryan, Capital Michael Mc. Bryan, Drawing To close the owner’s drawing account 3, 100 3, 900 3, 100