Copyright © Cengage Learning. All rights reserved. Chapter 3 Measuring Business Income.

Copyright © Cengage Learning. All rights reserved.

Chapter 3

Measuring Business Income

Copyright © Cengage Learning. All rights reserved. 3-2

Profitability Measurement: Issues and Ethics

• Objective 1– Define net income, and explain the assumptions

underlying income measurement and their ethical application.


Net Income

• Profitability is a major goal of a business.– For a business to survive, it must earn a profit

• Accountants prefer to use the term net income—the net increase in stockholders’ equity that results from a company’s operations.

• Net Income = Revenues – Expenses


Revenues• Increases in stockholders’ equity resulting from

– Selling goods

– Rendering services

– Performing other business activities

• Not all increases in stockholders’ equity arise from revenues– Increases resulting from stockholders’ investments do not represent

revenue

• When a company earns revenue, it usually receives – Cash

– A promise to be paid in the near future

• Recorded in either Accounts Receivable or Notes Receivable


Revenues (cont’d)

• Liabilities are usually not affected by 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


Expenses

• Decreases in stockholders’ equity resulting from costs of– Selling goods

– Rendering services

– Performing other business activities

• Also called the cost of doing business• Include costs of

– Goods sold

– Activities necessary to carry on a business

– Attracting and serving customers


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


Income Measurement Assumptions

• Continuity • Periodicity• Matching


Continuity

• Measuring transactions requires that certain expenses and revenues be allocated over several accounting periods.

• The accountant assumes the business is a going concern (the business will continue to operate indefinitely, unless there is evidence to the contrary).

• This allows the cost of certain assets to be held on the balance sheet until a future year, when they will become expenses on the income statement.


Periodicity

• Addresses the difficulty of assigning revenues and expenses to a specific period of time.

• Accountants make an assumption about periodicity: The net income for any period of time less than the life of the business, although tentative, is still 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.


Matching• Addresses the difficulty of assigning revenues and expenses

to the appropriate accounting period so that net income is measured accurately

• Problem:– Revenues can be earned in a period other than the one in which cash

is received– Expenses can be incurred in a period other than the one in which

cash is paid

• Solution:– The matching rule

• Assign revenues to the accounting period in which the goods are sold or services are rendered

• Assign expenses to the accounting period in which they are used to produce income


Earnings Management

The manipulation of revenues and expenses to achieve a specific outcome

Why do companies manage earnings?Meet previously announced goals Keep stock price steady Earn bonuses Avoid embarrassment


Accrual Accounting

• Objective 2– Define accrual accounting, and explain how it is

accomplished.


What Is Accrual Accounting?

• Encompasses all the techniques accountants use to apply the matching rule.

• Revenues and expenses are recorded in the periods in which they occur rather than in the periods in which they are received or paid.


Accrual Accounting

Accomplished in the following ways: 1. Recording revenues when earned

2. Recording expenses when incurred

3. Adjusting the accounts– Prepaid expenses (asset)– Payables (liability)


Adjustments and Ethics

• Adjustments do not affect cash flows in the current period and never involve the Cash account.

• Adjustments are important because they affect net income, profitability comparisons, and the balance sheet.

• Provide information about a company’s future cash inflows and outflow.


The Adjustment Process

• Objective 3– Identify four situations that require adjusting entries, and

illustrate typical adjusting entries.


Adjusting Entries

• Used to apply accrual accounting to transactions that span more than one accounting period

• Adjusting entries must– Include at least one balance sheet account

– Include at least one income statement account

– Never affect the Cash account


When to Make Adjustments

Type 1: Allocating recorded costs between two or more accounting periods

Type 2: Recognizing unrecorded expenses

Type 3: Allocating recorded, unearned revenues between two or more accounting periods

Type 4: Recognizing unrecorded, earned revenues


Deferrals

• A deferral is the postponement of– The recognition of an expense already paid in advance

• Type 1 adjustment

– The recognition of a revenue received in advance• Type 3 adjustment


Accruals

• An accrual is the recognition of– A revenue that has arisen but has not yet been recorded

• Cash will be received in a future period


– An expense that has arisen but has not yet been recorded • Cash will be paid in a future period



Deferred Expenses• The postponement of the recognition of expenses

already paid • Require allocating recorded costs between two or

more accounting periods– Recorded costs

• Expenditures that benefit more than one accounting period• Usually debited to an asset account• At the end of the accounting period the amount that has

been used is transferred to an expense account

• Prepaid expenses and depreciation of plant and equipment are two types of adjustments involving deferred expenses


Prepaid Expenses• Expenses paid in advance that have not yet expired

• Are recorded as assets

• A certain portion expires at the end of an accounting period

• An adjusting entry is made to reduce the asset and increase the expense– The amount of the adjustment equals the cost of goods or services

used up or expired

– If adjustments for prepaid expenses are not made at the end of the accounting period

• Assets will be overstated

• Expenses will be understated

• Stockholders’ equity will be overstated

• Net income will be overstated


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 accountand one income statement account

(Accrued Expenses)(Deferred Expenses)

(Accrued Revenues)(Deferred Revenues)


July 3 3,200

Type 1: Prepaid Rent Adjustment

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.

1,600 July 31 July 31 1,600

Bal. 1,600

The account now reflects the prepaid August amount

The account now reflects the July rent expense amount

Prepaid Rent

On July 3, Miller Design Studio paid two months’ rent in advance for $3,200. The amount was recorded in the Prepaid Rent account.


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.


Depreciation Expense

• Is incurred during an accounting period to produce revenue

• Must be estimated– The useful life of the asset is estimated

– 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.


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.


Type 2 Adjustment: Accrued Expenses

• Expenses that are incurred but not yet recorded• At the end of the accounting period the amount that

has been incurred is recorded in – An expense account– The corresponding liability account

• As the expense and liability accumulate, the are said to accrue

• Common unrecorded (accrued) expenses or payables– Interest– Taxes– Wages


Adjustment July 31: Accrue the wages expense and payable. The assistant earns $2,400 every two weeks. ($240/day x 3 days = $720)

The wages for July 29 – 31 are an expense of July even though they will not be paid until August.

Wages Payable

Type 2: Wages Adjustment Illustrated

Wages Expense

720 July 31 July 31 720

The account now reflects the wages applicable to July

The account now reflects the total July wages expense

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 assistant worked July 29 – 31, but will not be paid until the regular payday in August.

Bal. 5,520


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.


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.


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 Revenues Design Revenues

July 31 800 800 July 31

The account now reflects a balance that is unearned revenue

The account now reflects the revenue applicable to July for this contract

July 31 Unearned Design Revenues 800 Design Revenues 800

1,400 July 19

On July 19, Miller Design Studio 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 received, it was recorded as a liability.

600 Bal.

Type 3: Unearned Revenue Adjustment


Type 4: Accrued Revenues

• Revenues earned but not yet recorded.• At the end of the accounting period, record the

amount that has been earned in– A revenue account

• To record the amount of revenue that has been earned

– The Accounts Receivable account (an asset account)• To record amounts due to the company for services

performed


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 Design Revenue

July 31 400

The account now reflects all receivables for July

The account now reflects the revenue applicable to July for this contract

July 31 Accounts Receivable 400 Design Revenue 400

July 15 9,600

In July, Miller Design Studio agreed to create two advertisements for Maggio’s Pizza Company, with the first ad completed by July 31. The fee for this first completion is $400.

Bal. 5,000

5,000 July 22 2,800 July 10 9,600 July 15

400 July 31 800 July 31

13,600 Bal.

Type 4: Unrecorded Revenue Adjustment


Stop & Review

Q. What do plant and equipment, office supplies, and prepaid insurance have in common?

A. They are all assets, their costs must be allocated to expenses as they are used over time, and they require adjusting entries at the end of the accounting period.


Using the Adjusted Trial Balance to Prepare Financial Statements

• Objective 4– Prepare financial statements from an adjusted trial

balance.


Adjusted Trial Balance

• A trial balance prepared after all adjusting entries have been recorded and posted to the accounts

• Total debits = total credits• The financial statements can easily be prepared

from the adjusted trial balance


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


Chapter Review

1. Define net income, and explain the assumptions underlying income measurement and their ethical application.

2. Define accrual accounting, and explain how it is accomplished.

3. Identify four situations that require adjusting entries, and illustrate typical adjusting entries.

4. Prepare financial statements from an adjusted trial balance.


Chapter Review (cont’d)

4. Prepare financial statements from an adjusted trial balance.

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