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Measuring Business Income Chapter 3 Net Income The net increase in stockholders’ equity that results from operations of a company Accumulated in the R/E account NI or NL = Revenues - expenses Revenues The price of goods sold or services rendered over a specific period of time.

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net income
Net Income
  • The net increase in stockholders’ equity that results from operations of a company
  • Accumulated in the R/E account
  • NI or NL = Revenues - expenses
revenues
Revenues
  • The price of goods sold or services rendered over a specific period of time.
  • Not all cash receipts are revenues
  • Cash receipts for reducing accounts receivable are not revenues
expenses
Expenses
  • Costs of the goods and services used up in the course of earning revenues
  • Including
    • Costs of goods sold
    • Costs of carrying on a business
expenses5
Expenses
  • Not all cash payments are expenses
  • Be aware of a two-step process to incur expenses, e.g.,
    • Prepaid rent as an asset and when the rent is used up over time, it become an expense.
    • A building bought is an asset. For each accounting period, a portion of the building is “used up” to become an expense
periodicity
Periodicity
  • An assumption
  • Assuming that the net income for a period of time is still a useful estimate of an entity’s profitability for the period
  • Net worth and Investment horizon are two concepts interacting with the usefulness of periodicity assumption
accounting period
Accounting period
  • Fiscal year versus calendar year
  • More like to choose a fiscal year that ends during a slack season
  • For example, the last month of fiscal year for The Walt Disney Company is September – a slack season
continuity issue
Continuity issue
  • Going concern assumption
  • Unless there is evidence to the contrary, the accountant assumes that the business will continue to operate indefinitely
liquidation value
Liquidation value
  • The value of assets to a going concern is much higher than the value of assets to a firm facing bankruptcy
  • Book value vs. stock price
  • Some company may have $10 book value but stock price went down to only $2.50
cash basis of accounting
Cash basis of accounting
  • Some for income tax purposes
  • Revenues are reported in the period in which cash is received
  • Expenses are reported in the period in which cash is paid
  • Challenges?
accrual accounting
Accrual accounting
  • Attempts to record the financial effects in the periods in which those transactions, events, and circumstances occur rather than only in the periods in which cash is received or paid.
  • How? Applying the matching rule
accrual accounting12
Accrual accounting
  • By recording revenues when earned and expenses when incurred, and
  • By adjusting the accounts
revenue recognition
Revenue recognition
  • Recognized when earned
  • If cash payment is not received, use accounts receivable or notes receivable as holding accounts until payment is received
adjusting the accounts
Adjusting the accounts
  • Adjustments are necessary because the accounting period ends before the use-up of assets and the fulfillment of obligations of liabilities like the fact that some unearned revenues became earned during the period
adjusting entries
Adjusting entries
  • Never involve the cash account
  • Require judgement
  • A potential area for abuse and misrepresentation
  • Affect profitability, balance sheet accounts
adjusting entries16
Adjusting entries
  • Adjusting the use-up of assets – reclassified as expenses
  • Adjusting the fulfillment of unearned revenues (liabilities) – reclassified as revenues
  • Revenues earned but not recorded yet – recorded as accounts receivable (asset)
  • Expenses incurred but not yet recorded – recorded as accounts payable (liability)
adjusting entries17
Adjusting entries
  • Recorded some assets and liabilities will be reclassified as expenses and revenues, respectively
  • Unrecorded revenues and expenses will be recorded as assets and liabilities
recorded assets
Recorded assets
  • E.g. prepaid rent, prepaid insurance, supplies, buildings, etc.
  • Allocation of the used-up portion
prepaid rent
Prepaid rent
  • P. 140
  • Paid two months’ rent in advance
  • By period end, in this case, Jan. 31, a month rent should be classified as expense
  • Expense increase  debit
  • Use credit to reduce asset account  credit prepaid rent
unrecorded expenses
Unrecorded expenses
  • E.g. interest expenses, taxes, wages, utilities for those unpaid portions
  • Accrue means to accumulate over time; thus those expenses will be called accrued expenses
accrued expenses
Accrued expenses
  • P. 145
  • The end of the accounting period ended on Wed. and thus it accumulates three days unpaid expenses
  • How much is one day wage expense?