1. Chapter 3 Measuring Business Income Skyline College

2. 3–23–2 Copyright © Houghton Mifflin Company. All rights reserved. Why Must a Business Be Profitable? To succeed To survive To increase stockholders’ equity To demonstrate positive performance Accountants use the term net income when referring to profitability © Royalty Free C Squared Studios/ Getty Images

3. 3–33–3 Copyright © Houghton Mifflin Company. 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 © Royalty-Free/Corbis + _

4. 3–43–4 Copyright © Houghton Mifflin Company. All rights reserved. Revenues Increases in stockholders’ equity resulting from… selling goods rendering services performing other business activities Cash Received Promise to Pay Received (Accounts Receivable) Not all increases in stockholders’ equity arise from revenues (Example: Issue stock) © Royalty Free Digital Vision/ Getty Images

5. 3–53–5 Copyright © Houghton Mifflin Company. All rights reserved. Expenses Decreases in stockholders’ equity resulting from the cost of… selling goods rendering services performing other business activities Cost of doing business Salaries Expense Rent Expense Utilities Expense Depreciation of a building Not all decreases in stockholders’ equity arise from expenses (Example: Dividends, net losses) © Royalty Free C Squared Studios/ Getty Images

6. 3–63–6 Copyright © Houghton Mifflin Company. 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?

7. 3–73–7 Copyright © Houghton Mifflin Company. All rights reserved. Continuity 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. $

8. 3–83–8 Copyright © Houghton Mifflin Company. All rights reserved. Periodicity Assigns revenue and expenses to a specific time period Time periods are of equal length The 12-month accounting period is called a fiscal year (does not have to correspond with the calendar year) Monthly or quarterly periods are called interim periods © Royalty Free C Squared Studios/ Getty Images

9. 3–93–9 Copyright © Houghton Mifflin Company. All rights reserved. What Is Accrual Accounting? Revenues and expenses are recorded in the periods in which they occur regardless when cash is received or paid Accrual accounting is accomplished by: Recording revenues when earned Recording expenses when incurred Adjusting the accounts © Royalty Free C Squared Studios/ Getty Images

10. 3–10 Copyright © Houghton Mifflin Company. 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 exists delivery has occurred or services have been rendered seller’s price to buyer is fixed or determinable collectibility is reasonably assured

11. 3–11 Copyright © Houghton Mifflin Company. All rights reserved. Revenue Recognition Illustrated Treadle Website Design, Inc. designs a website for a customer under a predetermined agreement and bills for the service. The customer understands the price and there is a reasonable expectation that the customer will pay the bill. Should Treadle recognize the revenue when it bills the customer? Because all four conditions have been met, Treadle should recognize the revenue by debiting Accounts Receivable and crediting Design Revenue.

12. 3–12 Copyright © Houghton Mifflin Company. All rights reserved. When Should Expenses Be Recognized? Record when these conditions are met: agreement exists to purchase goods or services goods have been delivered or services rendered a price is established or can be determined goods or services have been used to produce revenue © Royalty-Free/Corbis

13. 3–13 Copyright © Houghton Mifflin Company. All rights reserved. Expense Recognition Illustrated Treadle Website Design, Inc. receives its utility bill for the period. Should Treadle recognize the expense when it receives the bill? Treadle has obviously entered into an agreement to pay for utility services as used. Because the expense has been incurred and has helped produce revenue, it should be recorded by debiting Utilities Expense and crediting Accounts Payable. © Royalty Free C Squared Studios/ Getty Images

14. 3–14 Copyright © Houghton Mifflin Company. 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

15. 3–15 Copyright © Houghton Mifflin Company. All rights reserved. Adjusting the Accounts Adjustments 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 © Royalty-Free/Corbis

16. 3–16 Copyright © Houghton Mifflin Company. All rights reserved. Impact of Adjustments Do not affect cash flows because they never involve the Cash account Affect one balance sheet account and one income statement account Necessary to measure profitability Affect profitability comparisons from one period to the next © Royalty Free C Squared Studios/ Getty Images

17. 3–17 Copyright © Houghton Mifflin Company. 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

18. 3–18 Copyright © Houghton Mifflin Company. 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 Expenses Depreciation of Plant and Equipment Amount consumed should be transferred from the asset account to an expense account © Royalty Free C Squared Studios/ Getty Images

19. 3–19 Copyright © Houghton Mifflin Company. All rights reserved. Prepaid Expenses Expenses 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 © Royalty-Free/Corbis

20. 3–20 Copyright © Houghton Mifflin Company. 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 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, Treadle Website Design paid two months’ rent in advance, $3,200. The amount was recorded in the Prepaid Rent account.

21. 3–21 Copyright © Houghton Mifflin Company. 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 © Royalty-Free/Corbis

22. 3–22 Copyright © Houghton Mifflin Company. 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 Treadle Website Design 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

23. 3–23 Copyright © Houghton Mifflin Company. 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

24. 3–24 Copyright © Houghton Mifflin Company. 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, Treadle Website Design 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 originally received, it was recorded as a liability. Bal. 600 July 10 2,800 July 15 9,600 July 31 800 Assets= Liabilities +Stockholders’ Equity July 31 Unearned Design Revenue 800 Design Revenue 800 Dr. Cr.

25. 3–25 Copyright © Houghton Mifflin Company. 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 © Royalty-Free/Corbis

26. 3–26 Copyright © Houghton Mifflin Company. 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, Treadle Website Design 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 5,000July 10 2,800 July 16 9,600 July 31 400 July 31 800

27. 3–27 Copyright © Houghton Mifflin Company. All rights reserved. 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 © Royalty Free C Squared Studios/ Getty Images

28. 3–28 Copyright © Houghton Mifflin Company. 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. © Royalty Free C Squared Studios/ Getty Images

29. 3–29 Copyright © Houghton Mifflin Company. All rights reserved. Sequence for Preparing Financial Statements

30. 3–30 Copyright © Houghton Mifflin Company. All rights reserved. Overview of the Accounting Cycle

31. 3–31 Copyright © Houghton Mifflin Company. All rights reserved. The Closing Process: Which Accounts Are Closed? Are closed at the end of each period so the accounts can start counting the next period’s activity Revenue and expense accounts and the Dividends account Temporary accounts accounts begin each period with a zero balance Balance sheet accounts Permanent accounts carry their end- of-period balances to next period

32. 3–32 Copyright © Houghton Mifflin Company. 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 © Royalty Free C Squared Studios/ Getty Images

33. 3–33 Copyright © Houghton Mifflin Company. All rights reserved. The Closing Process Expense AccountsRevenue Accounts Income Summary Retained EarningsDividends xxx xx Step 1: Close revenue accounts xxx Step 2: Close expense accounts xx Step 3: Close Income Summary xxStep 4: Close Dividends account Balance _ + Balance _ xxx + _ + Balance + Balance _ xx + _

34. 3–34 Copyright © Houghton Mifflin Company. All rights reserved. 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 © PhotoDisc Collection/ Getty Images