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

2. 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.

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

4. Copyright © Cengage Learning. All rights reserved. 3-4 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

5. Copyright © Cengage Learning. All rights reserved. 3-5 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

6. Copyright © Cengage Learning. All rights reserved. 3-6 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

7. Copyright © Cengage Learning. All rights reserved. 3-7 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

8. Copyright © Cengage Learning. All rights reserved. 3-8 Income Measurement Assumptions Continuity Periodicity Matching

9. Copyright © Cengage Learning. All rights reserved. 3-9 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.

10. Copyright © Cengage Learning. All rights reserved. 3-10 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.

11. Copyright © Cengage Learning. All rights reserved. 3-11 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

12. Copyright © Cengage Learning. All rights reserved. 3-12 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

13. Copyright © Cengage Learning. All rights reserved. 3-13 Accrual Accounting Objective 2 –Define accrual accounting, and explain how it is accomplished.

14. Copyright © Cengage Learning. All rights reserved. 3-14 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.

15. Copyright © Cengage Learning. All rights reserved. 3-15 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)

16. Copyright © Cengage Learning. All rights reserved. 3-16 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.

17. Copyright © Cengage Learning. All rights reserved. 3-17 The Adjustment Process Objective 3 –Identify four situations that require adjusting entries, and illustrate typical adjusting entries.

18. Copyright © Cengage Learning. All rights reserved. 3-18 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

19. Copyright © Cengage Learning. All rights reserved. 3-19 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

20. Copyright © Cengage Learning. All rights reserved. 3-20 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

21. Copyright © Cengage Learning. All rights reserved. 3-21 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 Type 4 adjustment –An expense that has arisen but has not yet been recorded Cash will be paid in a future period Type 2 adjustment

22. Copyright © Cengage Learning. All rights reserved. 3-22 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

23. Copyright © Cengage Learning. All rights reserved. 3-23 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

24. Copyright © Cengage Learning. All rights reserved. 3-24 Four Types of Adjustments Notice that each adjusting entry involves one balance sheet account and one income statement account (Accrued Expenses)(Deferred Expenses) (Accrued Revenues) (Deferred Revenues)

25. Copyright © Cengage Learning. All rights reserved. 3-25 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.

26. Copyright © Cengage Learning. All rights reserved. 3-26 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.

27. Copyright © Cengage Learning. All rights reserved. 3-27 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.

28. Copyright © Cengage Learning. All rights reserved. 3-28 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.

29. Copyright © Cengage Learning. All rights reserved. 3-29 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

30. Copyright © Cengage Learning. All rights reserved. 3-30 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

31. Copyright © Cengage Learning. All rights reserved. 3-31 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.

32. Copyright © Cengage Learning. All rights reserved. 3-32 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.

33. Copyright © Cengage Learning. All rights reserved. 3-33 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 RevenuesDesign 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

34. Copyright © Cengage Learning. All rights reserved. 3-34 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

35. Copyright © Cengage Learning. All rights reserved. 3-35 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 ReceivableDesign 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

36. Copyright © Cengage Learning. All rights reserved. 3-36 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.

37. Copyright © Cengage Learning. All rights reserved. 3-37 Using the Adjusted Trial Balance to Prepare Financial Statements Objective 4 –Prepare financial statements from an adjusted trial balance.

38. Copyright © Cengage Learning. All rights reserved. 3-38 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

39. Copyright © Cengage Learning. All rights reserved. 3-39 Sequence for Preparing Financial Statements

40. Copyright © Cengage Learning. All rights reserved. 3-40 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.

41. Copyright © Cengage Learning. All rights reserved. 3-41 Chapter Review (cont’d) 4.Prepare financial statements from an adjusted trial balance.