Chapter 3 Measuring Business Income

1. Chapter 3Measuring Business Income

2. LEARNING OBJECTIVES 1.Define net incomeand 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 accountingand explain two broad ways of accomplishing it.

3. LEARNING OBJECTIVES (continued) 4.State four principal situations that require adjusting entries. 5.Prepare typical adjusting entries. 6.Prepare financial statements from an adjusted trial balance.

4. Profitability Measurement:The Role of Business Income Objective 1 Define net income and its two major components, revenues and expenses.

5. Profitability Measurement: The Role 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 incomeis the preferred term because it can be defined more precisely from an accounting point of view.

6. Net Income • Net incomeis 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.

7. Revenues • 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.

8. Expenses • 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.

9. Discussion 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.

10. The Accounting Period Issue Objective 2a Explain the difficulties of income measurement caused by the accounting period issue.

11. The 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 aboutperiodicity. • 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.

12. The Measurement of Business Income • Financial statements may be prepared for any time period, usually a calendar year. • Accounting periods of less than one year are called interimperiods. • Thefiscal 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.

13. Fiscal Year Examples • Year ended June 30, 2001(The year starts on July 1, 2001 and concludes on June 30, 2002.)

14. Discussion 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.

15. The Continuity Issue Objective 2b Explain the difficulties of income measurement caused by the continuity issue.

16. The 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 isagoing concern,that theentity 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.

17. The Matching Issue Objective 2c Explain the difficulties of income measurement caused by the matching issue.

18. The 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.

19. Revenues are recorded in the books when they are earned. Expenses are recorded in the books when they are incurred. (happen) The Matching Rule/Principle

20. 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.

21. Accrual Accounting Objective 3 Define accrual accounting and explain two broad ways of accomplishing it. Pronounced ah-crew-ahl

22. Accrual 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.

23. Implementation of Accrual 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.

24. 2. By adjusting the accounts. • 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.

25. Discussion 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.

26. The Adjustment Process Objective 4 State four principal situations that require adjusting entries.

27. The Adjustment Process • Adjusting entriesare 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.)

28. Four 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.

29. Deferrals • Adeferralis thepostponement of: • The recognition of an expense already paid or • A revenue received in advance CASH HAS BEEN RECEIVED OR PAID AHEAD OF TIME!!!!!

30. Deferral means to set aside We are setting aside the recognition of revenue/expense.

31. Accruals • Anaccrualis therecognition of a revenue or expense that has arisen but has not yet been recorded.

32. Accrual means to gather We can tell an accrual entry because an account ending in “ble” is debited or credited. Receivable/Payable

33. Discussion 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.

34. Allocating Recorded Costs Between Two or More Accounting Periods Objective 5 Prepare typical adjusting entries.

35. 3-1 3-1 Asset Account Expense Account Asset Account Expense Account Adjusting Adjusting Adjusting Adjusting Entry Entry Entry Entry Credit Debit Credit Debit Amount equals cost Amount equals cost of goods or services of goods or services used up or expired used up or expired Adjustment for Prepaid Expenses

36. Short Exercise 2: AllocatingDeferred ExpensesPrepaid Expenses: Insurance Expense Turn to your text, page 159

37. Prepaid Insurance • Transaction • Analysis • Rules • Entry Beg Bal 230 Additions 570 Balance 800 Short Exercise 2: AllocatingDeferred ExpensesPrepaid Expenses: Insurance Expense

38. The 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.

39. Dr.Cr. Dec. 31 Insurance Expense 450 Prepaid Insurance 450 Prepaid Insurance • Transaction • Analysis • Rules • Entry Bal Before Adj 800 Dec. 31 450 Insurance Expense Dec. 31 450 Short Exercise 2: AllocatingDeferred ExpensesPrepaid Expenses: Insurance Expense

40. Dr.Cr. Dec. 31 Insurance Expense 450 Prepaid Insurance 450 Prepaid Insurance • Transaction • Analysis • Rules • Entry Bal Before Adj 800 New Balance 350 Dec. 31 450 Insurance Expense Dec. 31 450 Short Exercise 2: AllocatingDeferred ExpensesPrepaid Expenses: Insurance Expense

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

42. Part b of Problem 2 • There are three policies:

43. Part b of Problem 2 • There are three policies: • The policy for $7,160 in the beginning balance has expired. • It is now November 30th.

44. First Policy, Problem 2 part b

45. Part b of Problem 2 • 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!

46. First and Second Policies, Problem 2 part b

47. First and Second Policies, Problem 2 part b

48. Part 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

49. All of the Insurance, Problem 2 part b 14544/36 months x 2 mos.

50. All of the Insurance, Problem 2 part b Balance in the account before adjustment Expense Amount Prepaid