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3–2Copyright © 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’ equityTo demonstrate positive performance
Accountants use the term net income when referring to profitability
3–3Copyright © 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
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3–4Copyright © Cengage Learning. All rights reserved.
RevenuesIncreases in stockholders’ equity resulting from…
selling goods rendering services performing other business
activities
Cash Received Promise to Pay Received(Accounts Receivable)
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3–5Copyright © 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
3–6Copyright © Cengage Learning. All rights reserved.
ExpensesDecreases in stockholders’ equity resulting from the cost of… selling goods rendering services performing other business
activities
Cost of doing business
Salaries ExpenseRent ExpenseUtilities ExpenseDepreciation of a building
Not all decreases in stockholders’ equity arise from expenses (Example: Dividends)
3–7Copyright © Cengage Learning. All rights reserved.
Expenses
Cost of doing business
Salaries ExpenseRent ExpenseUtilities ExpenseDepreciation 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
3–8Copyright © 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
3–9Copyright © 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?
3–10Copyright © Cengage Learning. All rights reserved.
ContinuityMeasuring 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.
$
3–11Copyright © Cengage Learning. All rights reserved. 3-11
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.
3–12Copyright © Cengage Learning. All rights reserved. 3-12
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
3–13Copyright © Cengage Learning. All rights reserved.
MatchingRevenues 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…
3–14Copyright © Cengage Learning. All rights reserved. 3-14
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.
3–15Copyright © 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
3–17Copyright © Cengage Learning. All rights reserved.
Accrual Accounting
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3–18Copyright © 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
3–19Copyright © 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 existsdelivery has occurred or services have been rendered seller’s price to buyer is fixed or determinable collectibility is reasonably assured
3–20Copyright © Cengage Learning. All rights reserved.
When Should Expenses Be Recognized?
Record when these conditions are met: agreement exists to
purchase goods or servicesgoods have been delivered
or services rendered a price is established or
can be determinedgoods or services have
been used to produce revenue
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3–21Copyright © Cengage Learning. All rights reserved.
Adjusting the AccountsAdjustments 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
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3–22Copyright © 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
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3–24Copyright © Cengage Learning. All rights reserved. 3-24
Four Types of Adjustments
Assets Liabilities
Expense
1. Recorded costs are
allocated between two or more accounting periods
2. Expenses are
incurred but not yet recorded
Revenue
4. Revenues are
earned but not yet recorded
3. Recorded unearned
revenues are allocated between two or more accounting periods
INC
OM
E S
TA
TE
ME
NT
BALANCE SHEET
Notice that each adjusting entry involves one balance sheet account
and one income statement account
(Accrued Expenses)(Deferred Expenses)
(Accrued Revenues)(Deferred Revenues)
3–25Copyright © 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
3–26Copyright © 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 ExpensesDepreciation of Plant and Equipment
Amount consumed should betransferred from the asset accountto an expense account
3–27Copyright © Cengage Learning. All rights reserved.
Prepaid ExpensesExpenses 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
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3–28Copyright © 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 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.
3–29Copyright © Cengage Learning. All rights reserved. 3-29
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.
3–30Copyright © Cengage Learning. All rights reserved. 3-30
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.
3–31Copyright © Cengage Learning. All rights reserved. 3-31
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.
3–32Copyright © 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
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3–33Copyright © 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 31 720
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
3–34Copyright © Cengage Learning. All rights reserved. 3-34
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.
3–35Copyright © 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
3–36Copyright © Cengage Learning. All rights reserved. 3-36
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.
3–37Copyright © 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 31 800
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 2,800July 15 9,600
July 31 800
Assets = Liabilities + Stockholders’ Equity
July 31 Unearned Design Revenue 800 Design Revenue 800
Dr. Cr.
3–38Copyright © 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
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3–39Copyright © 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 31 400
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 5,000 July 10 2,800July 16 9,600
July 31 400July 31 800
3–40Copyright © Cengage Learning. All rights reserved.
Using the Adjusted Trial Balance to Prepare Financial Statements
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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
3–42Copyright © 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.
3–43Copyright © Cengage Learning. All rights reserved.
Sequence for Preparing Financial Statements
Income Statement Revenue accounts
– Expense accounts Net income
Balance Sheet Assets Asset accounts Liabilities Liability accounts Stockholders’ Equity Common stock Retained earnings
Statement of Retained Earnings Beginning retained earnings
+ Net Income – Dividends Ending retained earnings
Adjusted Trial Balance Asset accounts Liability accounts Common Stock Retained Earnings Dividends Revenue accounts Expense accounts
3–44Copyright © Cengage Learning. All rights reserved.
The Accounting Cycle
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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
3–47Copyright © 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
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The Closing ProcessExpense Accounts Revenue Accounts
Income Summary
Retained EarningsDividends
xxxxxx
xx
xx
Step 1: Close revenue accounts
xxxxxx
Step 2: Close expense accounts
xx
Step 3: Close Income Summary
xxStep 4: Close
Dividendsaccount
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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
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