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Measuring Business Income

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  1. Measuring Business Income Chapter 3

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. Continuity issue • Going concern assumption • Unless there is evidence to the contrary, the accountant assumes that the business will continue to operate indefinitely

  9. 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

  10. 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?

  11. 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

  12. Accrual accounting • By recording revenues when earned and expenses when incurred, and • By adjusting the accounts

  13. Revenue recognition • Recognized when earned • If cash payment is not received, use accounts receivable or notes receivable as holding accounts until payment is received

  14. 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

  15. Adjusting entries • Never involve the cash account • Require judgement • A potential area for abuse and misrepresentation • Affect profitability, balance sheet accounts

  16. 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)

  17. 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

  18. Recorded assets • E.g. prepaid rent, prepaid insurance, supplies, buildings, etc. • Allocation of the used-up portion

  19. 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

  20. 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

  21. 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?