Copyright©2001 by Houghton Mifflin Company. All rights reserved. 1 Financial Accounting Belverd E. Needles, Jr. Marian Powers - - - - - - - - - - - Multimedia

Copyright©2001 by Houghton Mifflin Company. All rights reserved.

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Financial AccountingFinancial AccountingBelverd E. Needles, Jr.Belverd E. Needles, Jr.

Marian PowersMarian Powers- - - - - - - - - - -

Multimedia Slides by:

Dr. Howard A. Kanter, CPADePaul University

Milton M. PressleyUniversity of New Orleans


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Chapter 3Chapter 3Measuring Business IncomeMeasuring Business Income

Belverd E. Needles, Jr.Belverd E. Needles, Jr.

Marian PowersMarian Powers- - - - - - - - - - -

Multimedia Slides by:

Dr. Howard A. Kanter, CPADePaul University

Milton M. PressleyUniversity of New Orleans


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LEARNING OBJECTIVESLEARNING OBJECTIVES

1. Define net income and its two major components, revenues and expenses.

2. Explain the difficulties of income measurement caused by:(a) the accounting period issue,

(b) the continuity issue,

(c) the matching issue.

3. Define accrual accounting and explain two broad ways of accomplishing it.


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4.State four principal situations that require adjusting entries.

5.Prepare typical adjusting entries.

6.Prepare financial statements from an adjusted trial balance.

LEARNING OBJECTIVESLEARNING OBJECTIVES (continued)(continued)


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Analyze cash flows from accrual-based information.

Supplemental ObjectivesSupplemental Objectives


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Profitability Measurement:Profitability Measurement:The Role of Business IncomeThe Role of Business Income

Objective 1Objective 1 Define net income and its two

major components, revenues and expenses.


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Profitability Measurement: The Role Profitability Measurement: The Role of Business Incomeof Business Income

Profitability and liquidity are the two major goals of a business.

To survive, a business must earn a profit. Profit, as a word, may be ambiguous. Net income is the preferred term because

it can be defined more precisely from an accounting point of view.


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Net IncomeNet Income

Net income is the net increase in stockholders’ equity that results from the operations of a company.

Net income is accumulated in the Retained Earnings account.

Net Income = Revenues - Expenses. R > E, net profit. R < E, net loss.


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RevenuesRevenues

Revenues are increases in SE resulting from selling goods or providing services.

Revenue for a given period equals:

Cash + Receivables from goods and services provided.

Liabilities are generally not affected by revenues.

Stockholders’ investments increase SE but are not revenues.


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ExpensesExpenses

Expenses are decreases in SE resulting from the costs of selling goods, rendering services, or performing other business activities.

Expenses are the costs of doing business. Not all cash payments are expenses. Prepaid expenses are recorded as assets. As

they expire, they become expenses. Not all decreases in SE arise from expenses. Dividends are not expenses.


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The Accounting Period IssueThe Accounting Period Issue

Objective 2aObjective 2a Explain the difficulties of

income measurement caused by the accounting period issue.


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The Accounting Period IssueThe Accounting Period Issue

The difficulty of assigning revenues and expenses to a short period of time.

Not all transactions can easily be assigned to a time period.

The accountant makes 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 net income for the period.

Time periods are usually of equal length for comparability.


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The Measurement of The Measurement of Business Income Business Income

Financial statements may be prepared for any time period, usually a calendar year.

Accounting periods of less than one year are called interim periods.

The fiscal year is the twelve-month accounting period used by a company.

Can be the same as the calendar year. Can be different from the calendar year as the needs of

the business dictate.


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The Continuity IssueThe Continuity Issue

Objective 2bObjective 2bExplain the difficulties of

income measurement caused by

the continuity issue.


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The Continuity IssueThe Continuity Issue

The measurement of business income requires that certain expenses and revenues be allocated over several accounting periods.

The continuity issue relates to the estimated number of accounting periods in the business entity’s life.

The accountant assumes that an entity is a going concern, that the entity will continue indefinitely.

If a firm is not a going concern, financial statements may be prepared on the basis of the liquidation value of the assets -- that is, what they will bring in cash.


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The Matching IssueThe Matching Issue

Objective 2cObjective 2c Explain the difficulties of

income measurement caused by the matching issue.


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The Matching IssueThe Matching Issue

The cash basis of accounting recognizes revenues when received in cash and expenses when paid in cash.

Cash basis accounting has matching problems. To adequately measure net income, revenues and

expenses must be assigned to the appropriate accounting period.

The matching rule states that: Revenues must be assigned to the accounting period

in which the goods are sold or services performed. Expenses must be assigned to the accounting period

in which they are used to produce revenue.


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Accrual AccountingAccrual Accounting

Objective 3Objective 3Define accrual accounting and

explain two broad ways of

accomplishing it.


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Accrual AccountingAccrual Accounting

Accrual accounting “attempts to record the financial effects on an enterprise of transactions and other events and circumstances . . . in the periods in which those transactions, events, and circumstances occur rather than only in the periods in which cash is received or paid by the enterprise.”

Accrual accounting is an application of the matching rule.


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Implementation of Implementation of Accrual AccountingAccrual Accounting

Accrual accounting is done in two ways.

1. By recording revenues when earned and expenses when incurred. When a sale is made on credit, revenue is

recorded before the cash is received in the Accounts Receivable account.

When an expense is incurred on credit, an expense is recorded before the cash is paid in the Accounts Payable account.


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Those transactions that span the cutoff period must be allocated to the proper accounting period.

A prepayment of 6 months’ office rent must be adjusted on a monthly basis if accurate monthly financial statements are to be prepared.

2. By adjusting the accounts.


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The Adjustment ProcessThe Adjustment Process

Objective 4Objective 4 State four principal situations that

require adjusting entries.


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The Adjustment ProcessThe Adjustment Process

Adjusting entries are used to apply accrual accounting to transactions that span more than one accounting period.

Adjusting entries involve at least one balance sheet account and at least one income statement account.

Adjusting entries never involve the Cash account.


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Four Types of Adjusting EntriesFour Types of Adjusting Entries

1. Costs have been recorded that must be allocated between two or more accounting periods.

2. Expenses have been incurred but are not yet recorded.

3. Revenues have been recorded that must be allocated between two or more accounting periods.

4. Revenues have been earned but not yet recorded.


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DeferralsDeferrals

The recognition of an expense already paid (Type 1 adjustment), or

A revenue received in advance (Type 3 adjustment).

A deferral is the postponement of:


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AccrualsAccruals

An accrual is the recognition of a revenue (Type 4 adjustment) or expense (Type 2 adjustment) that has arisen but has not yet been recorded.


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Allocating Recorded Costs Between Allocating Recorded Costs Between Two or More Accounting PeriodsTwo or More Accounting Periods

Objective 5Objective 5Prepare typical adjusting entries.


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Type 1: Type 1: AllocatingAllocating Deferred ExpensesDeferred ExpensesPrepaid Expenses: Rent ExpensePrepaid Expenses: Rent Expense

Dr. Cr. Jan. 31 Rent Expense 400 Prepaid Rent 400

Rent Expense

Jan. 31 400Jan. 31 400

Prepaid Rent•Transaction

•Analysis

•Rules

•Entry

Jan. 2 800 Jan. 31 400Jan. 31 400


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Type 1: Allocating Deferred ExpensesType 1: Allocating Deferred ExpensesPrepaid Expenses: Insurance ExpensePrepaid Expenses: Insurance Expense

Dr. Cr.Jan. 31 Insurance Expense 40 Prepaid Insurance 40

Insurance Expense

Jan. 31 40Jan. 31 40

Prepaid Insurance•Transaction

•Analysis

•Rules

•Entry

Jan. 8 480 Jan. 31 40Jan. 31 40


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Type 1:Type 1: Allocating Deferred Expenses Allocating Deferred ExpensesPrepaid Expenses: Art Supplies ExpensePrepaid Expenses: Art Supplies Expense

Dr. Cr.Jan. 31 Art Supplies Expense 500 Art Supplies 500

Art Supplies

Jan. 31 500Jan. 31 500

Art Supplies Expense

•Transaction

•Analysis

•Rules

•Entry

Jan. 6 1,800

Jan. 31 500Jan. 31 500


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Type 1: Type 1: AllocatingAllocating Deferred ExpensesDeferred ExpensesPrepaid Expenses: Office SuppliesPrepaid Expenses: Office Supplies

Dr. Cr.Jan. 31 Office Supplies Expense 200 Office Supplies 200

Office Supplies

Jan. 31 200Jan. 31 200

Office Supplies Expense

•Transaction

•Analysis

•Rules

•Entry

Jan. 6 800 Jan. 31 200Jan. 31 200


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Adjustment for Prepaid (Deferred) ExpensesAdjustment for Prepaid (Deferred) Expenses


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Type 1:Type 1: Allocating Deferred Expenses Allocating Deferred ExpensesDepreciation of PP&E: Art EquipmentDepreciation of PP&E: Art Equipment

Dr. Cr.Jan. 31 Depreciation Expense, Art Equipment 70 Accumulated Depreciation, Art Equipment 70

Accumulated Deprn, Art Equipment

Jan. 31 70Jan. 31 70

Depreciation Expense, Art Equipment

•Transaction

•Analysis

•Rules

•Entry Jan. 31 70Jan. 31 70


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Type 1:Type 1: Allocating Deferred Expenses Allocating Deferred ExpensesDepreciation of PP&E: Office EquipmentDepreciation of PP&E: Office Equipment

Dr. Cr.

Jan. 31 Depreciation Expense, Office Equipment 50 Accumulated Depreciation, Office Equipment 50

Accumulated Deprn, Office Equipment

Jan. 31 50Jan. 31 50

Depreciation Expense, Office Equipment

•Transaction

•Analysis

•Rules

•EntryJan. 31 50Jan. 31 50


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Adjustment for DepreciationAdjustment for Depreciation


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Type 2: Type 2: Recognizing Unrecorded (Accrued) Recognizing Unrecorded (Accrued) ExpensesExpenses

Accrued Expenses: Accrued WagesAccrued Expenses: Accrued WagesDr. Cr.

Jan. 31 Wages Expense 180 Wages Payable 180

Wages Payable

Jan. 31 180Jan. 31 180

Wages Expense

•Transaction

•Analysis

•Rules

•Entry

Jan. 12 600 26 600 31 18031 180


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Type 2: Type 2: Recognizing Unrecorded (Accrued) Recognizing Unrecorded (Accrued) ExpensesExpenses

Accrued Expenses: Estimated Income TaxesAccrued Expenses: Estimated Income Taxes

Dr. Cr.

Jan. 31 Income Taxes Expense 400 Income Taxes Payable 400

Income Taxes Payable

Jan. 31 400Jan. 31 400

Income Taxes Expense

•Transaction

•Analysis

•Rules

•EntryJan. 31 400Jan. 31 400


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Adjustment for Unrecorded (Accrued) ExpensesAdjustment for Unrecorded (Accrued) Expenses


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Type 3: Type 3: Allocating Deferred RevenuesAllocating Deferred RevenuesDeferred Revenues: Unearned FeesDeferred Revenues: Unearned Fees

Dr. Cr.Jan. 31 Unearned Art Fees 400 Art Fees Earned 400

Unearned Art Fees

Jan. 15 1,000

Art Fees Earned

•Transaction

•Analysis

•Rules

•Entry

Jan. 31 400Jan. 31 400

Jan. 31 400Jan. 31 400


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Adjustment for Unearned (Deferred) RevenuesAdjustment for Unearned (Deferred) Revenues


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Type 4: Type 4: Recognizing Unrecorded (Accrued) Recognizing Unrecorded (Accrued) RevenuesRevenues

Accrued Revenues: Advertising FeesAccrued Revenues: Advertising Fees

Dr. Cr.Jan. 31 Fees Receivable 200 Advertising Fees Earned 200

Fees Receivable

Jan. 31 200Jan. 31 200

Advertising Fees Earned

•Transaction

•Analysis

•Rules

•EntryJan. 10 1,400 19 2,800 31 20031 200


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Adjustment for Unrecorded (Accrued) RevenuesAdjustment for Unrecorded (Accrued) Revenues


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Using the Adjusted Trial Balance to Using the Adjusted Trial Balance to Prepare Financial StatementsPrepare Financial Statements

Objective 6Objective 6Prepare financial statements from an adjusted trial balance.


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The Adjusted Trial Balance (ATB)The Adjusted Trial Balance (ATB)

The ATB is prepared after adjusting entries have been recorded and posted.

The ATB is a listing of all accounts and their balances.

The ATB should have equal debits and credits.

Financial statements are prepared from the ATB by copying the appropriate accounts to the appropriate financial statement.


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Cash Flows, Accrual Accounting, Cash Flows, Accrual Accounting, and Management Objectivesand Management Objectives

Supplemental Objective 7Supplemental Objective 7 Analyze cash flows from

accrual-based information.


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Cash Flows from Accrual-Based Cash Flows from Accrual-Based InformationInformation

1. Management has a liquidity goal, which is measured by cash flow.


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2. Every revenue or expense account on the income statement has one or more related accounts on the balance sheet.

Supplies is related to Supplies Expense.

Wages Expense is related to Wages Payable.

3. Cash flows generated or paid by company operations may also be determined by analyzing these relationships.

4. The following rules may be applied to determine cash flow.


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Prepaid Expense

Ending balance + Expense for the period - Beginning balance = Cash payments for expenses.

Unearned Revenue

Ending balance + Revenue for the period - Beginning balance = Cash receipts from revenues.


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Accrued Expense Beginning balance + Expense for the period

- Ending balance = Cash payments for expenses.

Accrued Revenue

Beginning balance + Revenue for period

- Ending balance = Cash receipts from revenues.


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1. Define net income and its two major components, revenues and expenses.

2. Explain the difficulties of income measurement caused by:

(a) the accounting period issue,

(b) the continuity issue,

(c) the matching issue.

3. Define accrual accounting and explain two broad ways of accomplishing it.

OKAY, LET’S REVIEW...OKAY, LET’S REVIEW...


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4. State four principal situations that require adjusting entries.

5. Prepare typical adjusting entries.

6. Prepare financial statements from an adjusted trial balance.

7. Analyze cash flows from accrual-based information.

AND FINALLY...AND FINALLY...

Documents

Copyright©2001 by Houghton Mifflin Company. All rights reserved. 1 Financial Accounting Belverd E. Needles, Jr. Marian Powers - - - - - - - - - - - Multimedia