1 Accounting Systems ELS Preparing an Income Statement

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Accounting Systems

ELS

Preparing an Income Statement

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Time Period Assumption...

Divides the economic life of a business into artificial time periods

WHY?to provide immediate feedback on how the business is doing.

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Time Period Assumption...

Generally a month, a quarter, or a year.

An accounting time period that starts on January 1 and ends December 31 is

called a calendar year.

An accounting time period that is one year long is called fiscal year.

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Revenue Recognition Principle...

dictates that revenue be recognized in the accounting period in which it is earned.

is considered earned when the service has been provided or when the goods are delivered.

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Matching Principle...

requires that expenses be recorded

in the same period in which the

revenues they helped produce are

recorded.

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Cash Basis

Revenue recorded only when cash is received.Expense recorded only when cash is paid.

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Cash Basis in not GAAP

GA

AP

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Accrual Basis Accounting

Adheres to the:• Revenue Recognition Principle• Matching Principle

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Accrual Basis Accounting

•Revenue recorded only when earned, not when cash is received•Expense recorded only when incurred, not when cash paid

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Accrual Basis adheres to...

•Generally•Accepted•Accounting•Principles

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Year 1 Year 2

Purchased paint, painted building , paid employees

Received payment for work done in year one

Activity

Accrualbasis

Cashbasis

Revenue $80,000

Expense 50,000

Net Income $30,000

Revenue $ 0

Expense 50,000

Net Loss ( $50,000)

Revenue $80,000

Expense 0

Net Income $80,000

Revenue $ 0

Expense 0

Net Income $ 0

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Adjusting Entries

Adjusting entries make the:

revenue recognition &

matching principles

HAPPEN!

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Types of Adjusting Entries

Prepayments:Prepaid expenses: Expenses paid in cash and

recorded as assets before they are used or consumed.

Unearned Revenues: Cash received and recorded as liabilities before revenue is earned.

Accruals:Accrued revenues: Revenues earned but not yet

received in cash or recorded.Accrued expenses: Expenses incurred but not yet

paid in cash or recorded.

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Prepayments

•Cash or other asset has been spent but the item acquired has not been used or consumed

•Cash has been collected before revenue is earned

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You can start with the trial balance to find information to

adjust prepayments.

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Sierra CorporationTrial Balance

October 31, 2004

Debit Credit Cash $15,200Advertising Supplies 2,500Prepaid Insurance 600Office Equipment 5,000Notes Payable $ 5,000Accounts Payable 2,500Unearned Service Revenue 1,200Common Stock 10,000Dividends 500Service Revenue 10,000Salaries Expense 4,000Rent Expense 900 $28,700 $28,700

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On October 5 the company paid

$2,500 for advertising supplies.

GENERAL JOURNAL Debit Credit

Oct 5 Supplies 2,500 Cash 2,500

Purchased advertising supplies

Supplies2,500Oct 5

Cash2,500Oct 5

Supplies Expense

SuppliesIllustration 4-6

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An inventory on October 31 reveals that $1,000 of supplies remain on hand; therefore $1,500 of supplies have been used. ($2,500 - $1,000) =$ 1,500


Oct 5 Supplies Expense 1,500 Supplies 1,500

To record advertising supplies consumed

Supplies2,500 Oct 5

Cash2,500Oct 5

Supplies Expense

Supplies

1,500Oct 311,500Oct 31

Illustration 4-6

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Oct $1,500

Mar $1,435

Apr $1,510

May $1,592

Feb $1,601

Nov $1,800

Dec $1,410

Jan $1,425

June $1,652

July $1,621

Aug $1,427

Sept $1,555

Supplies expense is based on usage... so different amounts appear each month

Supplies Expense

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Prepaid Expenses

On October 1 the company paid $600 for a 1-year insurance policy. Coverage began

October 1.


Oct 1 Prepaid Insurance 600 Cash 600

Purchased one-year policy effective October 1

Prepaid Insurance

600Oct 1

Cash600Oct 1

Insurance Expense

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Insurance Policy

1 Year $ 600

Oct $50

Mar $50

Apr $50

May $50

Feb $50

Nov $50

Dec $50

Jan $50

June $50

July $50

Aug $50

Sept $50

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Prepaid ExpensesOn October 31st, $50 ($600/12 months) of the insurance was used-up

or expired.


Oct 31 Insurance Expense 50

Prepaid Insurance 50

Record insurance expense for the month

Prepaid Insurance

600Oct 1

Cash600Oct 1

Insurance Expense

50 Oct 3150 Oct 31

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How do you apply the Matching Principle to the cost of a long lived asset ?

Depreciation

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Allocate the cost of an asset to expense over its useful life

Depreciation is an ALLOCATION CONCEPT- not a VALUATION CONCEPT.

We’re not attempting to reflect the actual change in value of an asset!

Depreciation

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Office Equipment

Depreciation= $480/year

Oct $40

Mar $40

Apr $40

May $40

Feb $40

Nov $40

Dec $40

Jan $40

June $40

July $40

Aug $40

Sept $40

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Oct 31 Depreciation Expense 40

Accumulated Depreciation-Office Equip 40

To record monthly depreciation Accumulated depreciation is a

contra asset account - an offset against the fixed asset account.

Accumulated Depreciation-

Office Equipment40Oct 31

Office Equipment5,000Oct 2

Depreciation Expense

40 Oct 31

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Office equipment $ 5,000

Less : accumulated depreciation 40

$4,960

Balance Sheet Presentation

Book Value or Carrying Value

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Unearned RevenuesReceived on Oct. 2 $1,200 for advertising services expected to be completed by Dec 31.

Unearned Service RevenueCash

1,200Oct 21,200Oct 2

Service Revenue


Oct 2 Cash 1,200

Unearned Service Revenue 1,200

Collected money for work to be performed by Dec 31.

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Unearned RevenuesDuring October $400 of the revenue was

earned.

Unearned Service RevenueCash

1,200Oct 2

Service Revenue

1,200Oct 2


Oct 31 Unearned Service Revenue 400

Service Revenue 400

To record revenue earned

Oct. 31 400 Oct. 31 400

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Accrual

•Revenue has been earned, but not collected.

•Expenses have been incurred, but not yet paid.

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Accrued Revenues

Revenues earned but not yet received in cash or recorded at the statement date

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Accrued Revenues

Earned $200 for advertising services to clients in October, but they were not billed until after October 31st.


Oct 31 Accounts Receivable 200

Service Revenue 200

Accounts Receivable

200Oct 31

Service Revenue

200Oct 31

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Accrued Expenses

Expenses incurred but not yet paid or recorded at the statement date.

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Formula for Computing Interest

Face Value of Note Interest

Timein term of One Year

Annual Interest

Rate

$ 5,000 X 12% 1/12 = $50

Interest expense is the cost a company incurs to use money:Information needed to compute interest expense: face value of note interest rate (always expressed in annual rate) the length of time note is outstanding

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Interest Expense Interest Payable

Oct 31 50 Oct 31 50


Oct 31 Interest Expense 50 Interest Payable 50

Accrue interest expense for the month

Accrued Interest

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Accrued Salaries - Salaries Paid for after the Service Has Been Performed.

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Salaries Expense Salaries Payable

Oct 31 1,200 Oct 31 1,200


Oct 31 Salaries Expense 1,200

Salaries Payable 1,200

Accrue salary expense for the month

Accrued Salaries

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The adjusted trial balance is used to prove the equity of total debit balances and total credit balances after the adjusting entries have been made.

Financial statements can be easily prepared from the adjusted trial balance.

Adjusted Trial Balance

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SIERRA CORPORATIONAdjusted Trial Balance

For the Month Ended October 31, 2004

SIERRA CORPORATIONRetained Earnings Statement




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Balance as Oct. 31 fromRetained Earnings Statement



SIERRA CORPORATION Balance Sheet

October 31, 2004

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Closing the Books

Closing entries transfer the temporary account balances to the stockholders’ equity account...

and reduce the balances in the temporary accounts to zero.

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Temporary Permanent

All revenues accounts All asset accounts

All expense accounts All liability accounts

DividendsStockholders’ equity

accounts

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Retained Earnings is a permanent account; the others shown hereare temporary

Individual Expenses

Retained Earnings

Income Summary

Individual Revenues

Dividends

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3

4

2

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The Accounting Cycle

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Required Steps in the Accounting Cycle

Analyze business transactions.

Journalize the transactions.

Post to ledger accounts.

Prepare a trial balance.

Journalize and post adjusting entries--

prepayments and accruals.

Prepare an adjusting trial balance.

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Page 202 in book

SalesRevenue

Cost ofGoods Sold

GrossProfit

OperatingExpenses

Net Income (Loss)

Less

LessEquals

Equals

How Income is Measured in a Merchandising Company

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What Is Charged to Merchandise Inventory?

All costs of getting the inventory to company and ready to sell +Freight-In +Special Permits

Only costs associated with merchandise purchased for resale - not assets acquired for use, such as supplies

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Merchandise PurchasesOn May 4 the company bought $ 3,800 worth of merchandise from PW Audio

Supply, Inc.

Task:Record the purchase by getting information from the Purchase Invoice.The Purchase Invoice is a copy of the sales invoice.

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•1. Seller•2.Invoice Date•3.Purchaser•4.Salesperson•5.Credit terms•6.Freight terms•7.Goods sold: catalog no.,description,quantity, price per unit•8.Total invoice price

Invoice No. 731

Address 125 Main StreetAttention o f James Hoover, Purchasing Agent

Firm Name: Sauk Stero

City Chelsea State Illinois Zip 60915

Date5/4/04 Salesperson Maone Terms 2/10,n/30 Freight Paid by Buyer

Catalog No. Description QTY Price Amount

IMPORTANT: ALL RETURNS MUST BE MADE WITHIN 10 DAYS TOTAL $3,800

1,5003008Production ModelCircuits

A2547Z48

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Merchandise PurchasesOn May 4 the company bought $ 3,800 worth of merchandise from PW Audio

Supply, Inc.


May 4 Merchandise Inventory 3,800 Accounts Payable 3,800

To record goods purchased on account.

Accounts Payable

Merchandise Inventory

May 4 3,800

Freight-out May 4 3,800

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Purchases Returns and AllowancesOn May 8 the company returned $300 worth

of merchandise to PW Audio Supply, Inc.


May 8 Accounts Payable 300 Merchandise Inventory 300

To record goods returned that were purchased on account.

Accounts Payable


May 4 3,800

Freight-out May 4 3,800May 8 300 May 8 300

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Freight Costs - On Incoming Inventory

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Freight Costs - On Incoming InventoryOn May 6 the company paid $ 150 to have the merchandise inventory delivered to

them.


May 6 Merchandise Inventory 150

Cash 150

To record payment of freight.

Freight-Out


May 4 3,800

Cash May 6 150May 8 300

May 6 150

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Freight Costs - On Outgoing Inventory

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Freight Costs-on outgoing inventoryOn May 6 the seller company paid $ 150 to have merchandise inventory delivered to

the buyer.


May 6 Freight-Out 150

Cash 150

To record payment of freight on goods sold.

Freight-OutMerchandise

Inventory Cash May 6 150May 6 150

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Purchase Discounts

•Credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment.

•Credit terms specify the amount of cash discounts and the time period during which they are offered.

•2/10,n/30

•1/10 EOM

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Purchases Discounts

Review - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was paid within the discount period

Original Invoice $3,800

-Returns 300

Amount due before discount $3,500

2% discount 70

Net due $3,430

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Purchases DiscountsReview - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was paid within the discount period.


May 14 Accounts Payable 3,500

Cash 3,430 Merchandise Inventory 70

To record payment within discount period.

Accounts Payable


May 4 3,800

Cash May 4 3,800May 8 300 May 8 300

May 14 70 May 14 3,500

May 14 3430May 6 150

May 6 150

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Payment of InvoiceReview - Company purchased $3800 of merchandise and returned $300. The credit terms are 2/10, n/30 and the invoice was NOT paid within the discount period.


June 3 Accounts Payable 3,500

Cash 3,500

To record payment NOT within discount period.

Accounts Payable


May 4 3,800

Cash May 4 3,800May 8 300 May 8 300

Jun 3 3,500 Jun 3 3,500

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Sales Invoice ...

a business document that provides written evidence of a credit sale.

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•1. Seller•2.Invoice Date•3.Purchaser•4.Salesperson•5.Credit terms•6.Freight terms•7.Goods sold: catalog no.,description,quantity, price per unit•8.Total invoice price

Invoice No. 731

Address 125 Main StreetAttention o f James Hoover, Purchasing Agent

Firm Name: Sauk Stero

City Chelsea State Illinois Zip 60915

Date 5/4/04 Salesperson Maone Terms 2/10,n/30 Freight Paid by Buyer

Catalog No. Description QTY Price Amount

IMPORTANT: ALL RETURNS MUST BE MADE WITHIN 10 DAYS TOTAL $3,800

1,5003008Production ModelCircuits

A2547Z48

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Sales Revenues -Under a Perpetual System

are recorded when earned-revenue recognition principle

must be supported by a business document-written evidence

2 entries are made for each sale one to record sale one to record cost of merchandise sold

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Sales - under a perpetual systemAssume a sale of $ 3,800 ON ACCOUNT

CashAccounts

ReceivableMerchandise

Inventory

Cost of Goods Sold

Sales Returns & AllowancesSales

May 4 3,800

May 4 2,400

May 4 2,400

For merchandise having a cost of $2,400

May 4 3,800

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Sales Returns and AllowancesFlip side of purchase returns and

allowanceOn buyer’s books


May 8 Accounts Payable 300 Merchandise Inventory 300

To record goods returned that were purchased on account.

On seller’s books


May 8 Sales Returns and Allowance 300 Accounts Receivable 300

To record return of goods delivered to Sauk Stero.

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Sales - under a perpetual systemAssume a sale of $ 3,800 ON ACCOUNT

CashAccounts

ReceivableMerchandise

Inventory

Cost of Goods Sold

Sales Returns & AllowancesSales

May 4 3,800

May 4 2,400

May 4 2,400

For merchandise having a cost of $2,400

May 4 3,800

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What Is the Sales Returns and Allowances Account?

Contra Revenue Account to salesUsed to show how much came in on returns

and allowances

Excessive returns and allowances suggest:inferior merchandiseinefficiencies in filing orderserrors in billing customersmistakes in delivery or shipment of goods

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What Is the Sales Discount Account?

Contra Revenue Account to salesUsed to disclose amount of cash discounts

taken by customers

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Sales Discounts

Flip side of purchase discounts

On seller’s books


May 14 Cash 3,430 Sales Discounts 70

Accounts Receivable 3500

To record collection within discount period.

On buyer’s books


May 14 Accounts Payable 3,500 Cash 3,430 Merchandise Inventory 70

To record payment within discount period

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Two Forms OfIncome Statements

Single-step income statementMultiple-step income statement

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Single-Step Income Statement

One step… subtract total

expenses from total revenues

Revenues $10,000Expenses 3,000Net income $ 7,000

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PW AUDIO, Inc.Single-step Income Statement

For the Year Ended December 31, 2004

Sales $460,000Interest Revenue 3,000Gain on Sale of equipment 600

Total Revenues $463,600

ExpensesCost of goods sold $316,000

Selling expenses 76,000Administrative expenses 38,000Interest expense 1,800Casualty Loss from vandalism 200Income tax expense 10,100

Total expenses 442,100Net income $ 21,500

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Sales revenuesSales $ 480,000Less: Sales returns and allowance $12,000

Sales discounts 8,000 20,000Net sales 460,000Cost of goods sold 316,000Gross profit $ 144,000Operating expenses Selling expenses:

Store salaries expense $45,000 Advertising expense 16,000 Depreciation expense 8,000 Freight-out 7,000

Total selling expenses $76,000 Administrative expenses Salaries expense $19,000

Utilities expense 17,000 Insurance Expense 2,000

Total administrative expenses 38,000 Total operating expenses 114,000 Income from operations $ 30,000

PW AUDIO SUPPLY, INC.Multi-step Income Statement For the Year Ended

December 31, 2004

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Income from operations (continued) $ 30,000 Other revenues and gains Interest revenue $ 3,000 Gain on sale of equipment 600

$ 3,600Other expenses and losses Interest expense $ 1,800 Casualty loss from vandalism 200 2,000 1,600

31,600Income before income taxes Income tax expense 10,100Net income $21,500

PW AUDIO SUPPLY, INC.Multi-step Income Statement


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Cost of Goods Sold -Periodic Method

A running account of changes in inventory is not maintained.

Separate accounts use to record freight costs, returns and discounts

Cost of goods sold and ending inventory are calculated at end of period.

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Cost of goods sold Inventory, January 1 $ 36,000

Purchases $325,000Less Purchase returns and allowances $10,400Purchase discounts 6,800 17,200

Net purchases 307,800Add: Freight-in 12,200

Cost of goods purchased 320,000 Cost of goods available for sale 356,000 Inventory, December 31 40,000

Cost of goods sold 316,000

PW AUDIO SUPPLY, INC.Cost of Goods Sold


Documents

1 Accounting Systems ELS Preparing an Income Statement