Measuring business income
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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

  • The net increase in stockholders’ equity that results from operations of a company

  • Accumulated in the R/E account

  • NI or NL = Revenues - expenses

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  • 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

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  • 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

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  • 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

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  • 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

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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

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Continuity issue

  • Going concern assumption

  • Unless there is evidence to the contrary, the accountant assumes that the business will continue to operate indefinitely

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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

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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?

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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

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Accrual accounting

  • By recording revenues when earned and expenses when incurred, and

  • By adjusting the accounts

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Revenue recognition

  • Recognized when earned

  • If cash payment is not received, use accounts receivable or notes receivable as holding accounts until payment is received

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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

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Adjusting entries

  • Never involve the cash account

  • Require judgement

  • A potential area for abuse and misrepresentation

  • Affect profitability, balance sheet accounts

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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)

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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

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Recorded assets

  • E.g. prepaid rent, prepaid insurance, supplies, buildings, etc.

  • Allocation of the used-up portion

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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

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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

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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?