Chapter 3 Measuring Business Income

3-3-11Copyright Gayle M. Richardson, CPA, Professor. All rights reserved.

Chapter 3Chapter 3Measuring Business IncomeMeasuring Business Income


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.


4.State four principal situations that require adjusting entries.

5.Prepare typical adjusting entries.

6.Prepare financial statements from an adjusted trial balance.

LEARNING OBJECTIVES LEARNING OBJECTIVES (continued)(continued)


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

Objective 1 Define net income and its

two major components, revenues and expenses.

0

20

40

60

80

100

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

East

West

North


Profitability Measurement: The Profitability Measurement: The Role of Business IncomeRole of 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.


Net IncomeNet Income Net income is the net

increase in owner’s equity that results from the operations of a company.

Net Income = Revenues - Expenses.

R > E, net profit. R < E, net loss.


RevenuesRevenues Revenues are increases in OE

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.

Owner’s investments increase OE but are not revenues.


ExpensesExpenses Expenses are decreases in OE 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 OE arise from

expenses. Withdrawals are not expenses.


DiscussionDiscussion

Q. Why does the accountant use the term net income instead of profit?

A. Profit has many meanings. Accountants use the term net income to define the net increase in owner’s equity produced by business operations. Net income equals revenues minus expenses when revenues exceed expenses.


The Accounting Period IssueThe Accounting Period Issue

Objective 2a Explain the difficulties of

income measurement caused by the accounting period issue.


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.


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.


Fiscal Year ExamplesFiscal Year Examples

Year ended June 30, 2001

(The year starts on July 1, 2001 and concludes on June 30, 2002.)



Q. Why does the need for an accounting period cause problems?

A. Any measurement of net income over a short period of time is necessarily tentative, and not all transactions can be easily assigned to specific periods. It is necessary to recognize that the life of the business is a useful approximation of the net income for the period.


The Continuity IssueThe Continuity Issue

Objective 2bExplain the difficulties ofincome measurement

caused bythe continuity issue.


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.


The Matching IssueThe Matching Issue Objective 2c Explain the difficulties

of income measurement caused by the matching issue.


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.


The Matching Rule/PrincipleThe Matching Rule/Principle

Revenues arerecorded in the books when they are earned.

Expenses are recorded in the books when they are incurred. (happen)


Definition of “incur”Definition of “incur” To occur as a result or to bring down

upon oneself.

Example: A business incurs rent expense as it occupies a building. This expense happens every day as the business occupies the building.


Accrual AccountingAccrual Accounting

Objective 3Define accrual

accounting and explain two broad ways of accomplishing it.

Pronounced ah-crew-ahl


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.


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.


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.



Q. In what two ways is accrual accounting accomplished?

A. Accrual accounting is accomplished by (1) recording revenues when earned and expenses when incurred, and (2) making end-of-period adjustments to revenue and expense accounts.


The Adjustment ProcessThe Adjustment Process Objective 4 State four principal

situations that require adjusting entries.


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 (Note: this rule applies to this textbook.)


Four Types of Adjusting EntriesFour Types of Adjusting Entries Costs have been recorded that must be

allocated between two or more accounting periods.

Expenses have been incurred but are not yet recorded.

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

Revenues have been earned but not yet recorded.


DeferralsDeferrals

The recognition of an expense already paid or

A revenue received in advance

A deferral is the postponement of:

CASH HAS BEEN RECEIVED OR PAID AHEAD OF TIME!!!!!


Deferral means to set asideDeferral means to set aside

We are setting aside the

recognition of revenue/expense

.


AccrualsAccruals An accrual is the recognition

of a revenue or expense that has arisen but has not yet been recorded.


Accrual means to gatherAccrual means to gather

We can tell an accrual entry

because an account ending in “ble” is

debited or credited.Receivable/Payable



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

A. They are all assets that must be allocated to expenses over time; this means they all require adjusting entries at the end of the accounting period.


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

PeriodsPeriods

Objective 5Prepare typical adjusting

entries.


3-1

Asset Account Expense Account

Adjusting

Entry

Credit

Adjusting

Entry

Debit

Amount equals cost of goods or services used up or expired

3-1

Asset Account Expense Account

Adjusting

Entry

Credit

Adjusting

Entry

Debit

Amount equals cost of goods or services used up or expired

Adjustment for Prepaid ExpensesAdjustment for Prepaid Expenses


Short Exercise 2: Short Exercise 2: AllocatingAllocating Deferred Deferred ExpensesExpenses

Prepaid Expenses: Insurance ExpensePrepaid Expenses: Insurance ExpenseTurn to your text, page 159



Prepaid Expenses: Insurance ExpensePrepaid Expenses: Insurance Expense

Prepaid Insurance•Transaction

•Analysis

•Rules

•Entry

Beg Bal 230Additions 570Balance 800


The Balance is $800The Balance is $800

But this asset has to be adjusted to a balance

of $350, because this is the amount of the

resource that benefits a future period.



Prepaid Expenses: Insurance ExpensePrepaid Expenses: Insurance Expense Dr. Cr.

Dec. 31 Insurance Expense 450 Prepaid Insurance 450

Insurance Expense

Dec. 31 450Dec. 31 450


•Analysis

•Rules

•Entry

Bal Before Adj 800 Dec. 31 450Dec. 31 450



Prepaid Expenses: Insurance ExpensePrepaid Expenses: Insurance Expense Dr. Cr.

Dec. 31 Insurance Expense 450 Prepaid Insurance 450

Insurance Expense

Dec. 31 450Dec. 31 450


•Analysis

•Rules

•Entry

Bal Before Adj 800New Balance 350

Dec. 31 450Dec. 31 450


Part b of Problem 2Part b of Problem 2 Now for the insurance part of Problem 2…………….Turn to page 164 in your text --Prob 2,

part b


Part b of Problem 2Part b of Problem 2

There are three policies:



There are three policies: The policy for $7,160 in the beginning balance has expired.

It is now November 30th.


First Policy, Problem 2 part bFirst Policy, Problem 2 part b

Policy total $7,160

Amount expired $7,160

Amount unexpired 0



Second policy: The policy was purchased

on July 1 and will expire on June 30th.

Remember: it is now November 30th.So…..5 months have expired! July, August, September,

October and November. Use your fingers if you have to!


First and Second Policies, First and Second Policies, Problem 2 part bProblem 2 part b

Policy total

$7,160

Amount expired

$7,160

Amount unexpired

0$8,400 $3,500 $4,900


First and Second Policies, First and Second Policies, Problem 2 part bProblem 2 part b

Policy total

$7,160

Amount expired

$7,160

Amount unexpired

0$8,400$14,544

$3,500 $4,900


Part b of Problem 2Part b of Problem 2 Third policy: The policy purchased October 1 is good for 36 months. Two months have passed (October and November)

So 2/36 has expired


All of the Insurance, Problem 2 All of the Insurance, Problem 2 part bpart b

Policy total

$7,160

Amount expired

$ 7,160

Amount unexpired

0 8,400 3,500 $4,900

14,544 808 13,736

14544/36 months x 2 mos.


All of the Insurance, Problem 2 All of the Insurance, Problem 2 part bpart b

Policy total

$7,160

Amount expired

$ 7,160

Amount unexpired

0 8,400 3,500 $4,900

14,544 808 13,736

$30,104 $11,468 $18,636

Balance in the account before adjustment

Expense Amount Prepaid


Problem 2, Part b Problem 2, Part b Adjusting Journal Entry Adjusting Journal Entry (AJE)(AJE)

Dr. Cr. Nov 30 Insurance Expense 11,468 Prepaid Insurance 11,468

Insurance Expense

June 30 11,468June 30 11,468


•Analysis

•Rules

•Entry

Bal. B/4 Adjust 30,104New Balance 18,636

Nov. 30 AJE Nov. 30 AJE 11,46811,468


Short Exercise 3Short Exercise 3 Allocating Deferred Allocating Deferred ExpensesExpenses

Prepaid Expenses: Supplies ExpensePrepaid Expenses: Supplies Expense

Turn back to SE 3 on page 159



Prepaid Expenses: Supplies ExpensePrepaid Expenses: Supplies Expense

Supplies

Beg Bal 190Purchases 490Balance 680


The Balance is $680The Balance is $680

But this asset has to be adjusted to a balance

of $220, because this is the amount of supplies we actually have. The rest were used, so they

are an expense.



Prepaid Expenses: Supplies ExpensePrepaid Expenses: Supplies Expense Dr. Cr.

Dec. 31 Supplies Expense 460 Supplies 460

Supplies

Dec. 31 AJE 460Dec. 31 AJE 460

Supplies Expense

•Transaction

•Analysis

•Rules

•Entry

Bal.B/4 Adj 680Ending Bal 220

Dec. 31 AJE 460Dec. 31 AJE 460


Part a. of Problem 2Part a. of Problem 2Prepaid Expenses: Supplies ExpensePrepaid Expenses: Supplies Expense

Page 164 in text!


Part a. of Problem 2Part a. of Problem 2Prepaid Expenses: Supplies ExpensePrepaid Expenses: Supplies Expense

Supplies

Beg Bal 4,348Purchases 9,052Balance 13,400


Part a. of Problem 2 Part a. of Problem 2

The Balance is $13,400The Balance is $13,400

But this asset has to be adjusted to a balance of $2,794 because this

is the amount of supplies we actually have. The rest were used, so they are an

expense.


Computing the adjustmentComputing the adjustment

The unadjusted balance of $13,400 minus the actual

amount on hand of $2,794 equals

$10,606.


Part a. of Problem 2 Part a. of Problem 2 Dr. Cr.

June 30 Supplies Expense 10,606 Supplies 10,606

Supplies

Nov 30 AJE 10,606Nov 30 AJE 10,606

Supplies Expense

•Transaction

•Analysis

•Rules

•Entry

BB. 4,348Purchases 9,052

Bal B/4Adj 13,400

Nov 30 AJE 10,606Nov 30 AJE 10,606

Adjusted Bal 2,794


Depreciation of Property, Plant & EquipmentDepreciation of Property, Plant & Equipment

Depreciation is the matching of the cost of an asset to the period in which it was used to generate revenue.


Short Exercise 4Short Exercise 4Depreciation of PP&E:Office EquipmentDepreciation of PP&E:Office Equipment

Dr. Cr.Mar. 31 Depreciation Expense, Off Equipment 50 Accumulated Depreciation, Off Equipment 50

Accumulated Depn, Office Equipment

Mar. 31 50Mar. 31 50

Depreciation Expense, Offi ce Equipment

•Transaction

•Analysis

•Rules

•Entry Mar. 31 50Mar. 31 50

Page 159 in the text!


Mr. Ivey’s trick to remember the Mr. Ivey’s trick to remember the entryentry

Depreciation Expense

Accumulated Deprecation

Just remember DEAD


Adjustment for DepreciationAdjustment for Depreciation3-2

Accumulated Depreciation Depreciation Expense

Adjusting

Entry

Credit

Adjusting

Entry

Debit

Amount equals cost of asset allocated

to accounting period

CONTRA-ASSET ACCOUNT EXPENSE ACCOUNT


This is the third month of This is the third month of depreciation, so we did this two depreciation, so we did this two times before….for the months of times before….for the months of

January and February!January and February! The beginning balance in Accumulated

Deprecation was

$50 X 2mos.=$100


Short Exercise 4Short Exercise 4Depreciation of PP&E:Office EquipmentDepreciation of PP&E:Office Equipment

Dr. Cr.Mar. 31 Depreciation Expense, Off Equipment 50 Accumulated Depreciation, Off Equipment 50

Accumulated Depn, Office Equipment

Prev. BalPrev. Bal 100 100Mar. 31 Mar. 31 5050New Bal 150New Bal 150

Office Equipment

Bal 950

Contra-Asset Acct


Short Exercise 4Short Exercise 4

Balance Sheet PresentationBalance Sheet Presentation

Cash $ 100Accounts Receivable 100

Office Equipment $950 Less: Accumulated Depreciation 150

800Total Assets $1,000


Short Exercise #5 Short Exercise #5 Recognizing Unrecorded Recognizing Unrecorded ExpensesExpenses

Accrued Expenses: Accrued WagesAccrued Expenses: Accrued Wages



Accrued Expenses: Accrued WagesAccrued Expenses: Accrued Wages

Step 1: Compute the daily wage rate. Rules: All work weeks begin on Monday


Short Exercise #5 Recognizing Unrecorded ExpensesShort Exercise #5 Recognizing Unrecorded ExpensesAccrued Expenses: Accrued WagesAccrued Expenses: Accrued Wages

Step 1: Compute the daily wage rate. Wages for six days are $690$690 divided by six is



Step 1: Compute the daily wage rate. Wages for six days are $690$690 divided by six is $115



Step 2: Count the days in the year that has ended. If July 1 is Tuesday, the end of the year was Monday, June 30



Step 2: Count the days in the year that has ended. If July 1 is Tuesday, the end of the year was Monday, June 30

One day was in June



Step 2: Count the days in the year that has ended. If July 1 is Tuesday, the end of the year was Monday, June 30One day was in JuneThe daily wage rate was $115



Step 3: Multiply the days in the year that has ended by the daily wage rate and record the wages payable and wages expense. 1 X115 = $115



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

June 30 Wages Expense 115 Wages Payable 115

Wages Payable

June 30 115June 30 115

Wages ExpenseJune 30 115June 30 115


Now look at part g of problem 2 Now look at part g of problem 2 in your text.in your text.

Step 1: Compute the daily wage rate.

Step 2: Count the days in the year that has ended.

Step 3: Multiply the days in the year that has ended by the daily wage rate and record the wages payable and wages expense.

Step 4: Make the entry.


Now look at part g of problem 2 Now look at part g of problem 2 in your text.in your text.

Step 1: 24,600/6 =4,100 Step 2: Count the days in the year

that has ended = 4 days Step 3: 4 days times $4,100 =

16,400 Step 4: Salaries expense 16,400

Salaries payable 16,400


Part f of Problem 2: Part f of Problem 2: Recognizing Unrecorded Recognizing Unrecorded (Accrued) Expenses(Accrued) Expenses

Accrued Expenses: Interest ExpenseAccrued Expenses: Interest Expense


Part a of Problem 2: Part a of Problem 2: Recognizing Unrecorded Recognizing Unrecorded (Accrued) Expenses(Accrued) Expenses

Accrued Expenses: Interest ExpenseAccrued Expenses: Interest ExpenseDr. Cr.

Nov 30 Interest Expense 30,000 Interest Payable 30,000

Interest Payable

Nov 30 AJE 30,000Nov 30 AJE 30,000

Interest Expense

•Transaction

•Analysis

•Rules

•EntryNov 30 AJE 30,000Nov 30 AJE 30,000


3-5

Liability Account Expense Account

Adjusting

Entry

Credit

Adjusting

Entry

Debit

Amount equals cost of expense incurred

3-5

Liability Account Expense Account

Adjusting

Entry

Credit

Adjusting

Entry

Debit

Amount equals cost of expense incurred

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


Part e of Problem 2: APart e of Problem 2: Allocating Deferred llocating Deferred RevenuesRevenues

Deferred Revenues: Unearned FeesDeferred Revenues: Unearned Fees

When did we collect the $$$?

How much do we earn each month from this contract?

How much time has now passed?


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

Dr. Cr.Nov 30 Unearned Revenue 8,400 Fees Earned 8,400

Unearned Revenue

Sept. 1 33,600

Fees Earned

•Transaction

•Analysis

•Rules

•Entry

Nov. 30 AJE 8,400Nov. 30 AJE 8,400

Nov. 30 AJE 8,400Nov. 30 AJE 8,400

Nov 30 Adj. Bal 25,200

33,600/12 months times 3 months


3-3

Liability Account Revenue Account

Adjusting

Entry

Debit

Adjusting

Entry

Credit

Amount equals price of services performed

or goods delivered

3-3

Liability Account Revenue Account

Adjusting

Entry

Debit

Adjusting

Entry

Credit


or goods delivered

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


Part e of problem 2: Part e of problem 2: Recognizing Unrecorded Recognizing Unrecorded (Accrued) Revenues(Accrued) Revenues


Part h of problem 2: Part h of problem 2: Recognizing Unrecorded Recognizing Unrecorded (Accrued) Revenues(Accrued) Revenues

Dr. Cr.June 30 Fees Receivable 8,000 Service Revenue 8,000

Fees Receivable

Nov. 30 AJE 8,000Nov. 30 AJE 8,000

Service Revenue

Nov. 30 AJE 8,000Nov. 30 AJE 8,000


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

3-4

ASSET ACCOUNT

Receivable

REVENUE ACCOUNT

Revenue

Adjusting

Entry

Debit

Adjusting

Entry

Credit




Q. Where does unearned revenue appear on the balance sheet?

A. Unearned revenue appears as a liability on the balance sheet.


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

StatementsStatements Objective 6

Prepare financial statements from an adjusted trial balance.


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



Q. Why is the income statement the first statement prepared from the adjusted trial balance? A. The income statement is prepared first

because the net income figure is needed to complete the Statement of Owner’s Equity or Retained Earnings Statement in the case of a corporation. These are needed to prepare the Balance Sheet.


Need More Review?Need More Review?

To Better Understand How to Prepare the Financial Statements…View the

PowerPoint for Chapter 1 on Problem Solving.


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.

OK, LET’S REVIEW . . .


4. State four principal situations that require adjusting entries.

5. Prepare typical adjusting entries.

6. Prepare financial statements from an adjusted trial balance.

AND FINALLY . . .


The End

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Chapter 3 Measuring Business Income