Measuring Business Income 1– 1
Learning Objectives 1. Define net income and its two major components, revenues and expenses. 2. Explain how the income measurement issues of accounting period, continuity, and matching are resolved. 3. Define accrual accounting and explain two broad ways of accomplishing it. Copyright © Houghton Mifflin Company. All rights reserved. 3– 2
Learning Objectives (cont’d) 4. State four principal situations that require adjusting entries and prepare typical adjusting entries. 5. Prepare financial statements from an adjusted trial balance. 6. Analyze cash flows from accrual-based information. Copyright © Houghton Mifflin Company. All rights reserved. 3– 3
Profitability Measurement: The Role of Business Income • Objective 1 – Define net income and its two major components, revenues and expenses Copyright © Houghton Mifflin Company. All rights reserved. 3– 4
Profitability … is the ability to earn enough income to attract and hold investment capital • Profitability is a major goal of a business – For a business to survive, it must earn a profit • The term profit has many meanings depending on who is interpreting it – Economists – Lawyers – Accountants • Accountants often use the term net income Copyright © Houghton Mifflin Company. All rights reserved. 3– 5
Net Income …is the increase in owner's equity that results from the operations of a company Net Income = Revenues – Expenses When expenses exceed revenues a net loss occurs Copyright © Houghton Mifflin Company. All rights reserved. 3– 6
Revenues • Increases in owner's equity resulting from – Selling goods – Rendering services – Performing other business activities • Not all increases in owner's equity arise from revenues – Increases resulting from owner's investments do not represent revenue • When a company earns revenue, it usually receives – Cash – A promise to be paid in the near future • Recorded in either Accounts Receivable or Notes Receivable Copyright © Houghton Mifflin Company. All rights reserved. 3– 7
Revenues (cont’d) • Liabilities are usually not affected by revenues • Transactions that increase cash and other assets but are not revenues – A bank loan • Increases liabilities and cash – Collection of accounts receivable • Increases cash and decreases accounts receivable – Revenue was previously recorded when the sale took place Copyright © Houghton Mifflin Company. All rights reserved. 3– 8
Expenses • Decreases in owner's equity resulting from costs of – Selling goods – Rendering services – Performing other business activities • Also called the cost of doing business • Include costs of – Goods sold – Activities necessary to carry on a business – Attracting and serving customers Copyright © Houghton Mifflin Company. All rights reserved. 3– 9
Expenses (cont’d) • Transactions that decrease cash and other assets but are not expenses – Cash payments to reduce liabilities • Decrease cash and decrease a liability – The expense was recorded when the purchase took place – Owner withdrawals • Decrease cash and decrease owner’s equity – Withdrawals is an owner's equity account, not an expense account Copyright © Houghton Mifflin Company. All rights reserved. 3– 10
Prepaid Expenses and Plant Assets • Two steps required before an expenditure of cash becomes an expense 1. Prepaid expenses and plant assets are recorded as assets when acquired 2. Their cost is allocated to expenses as their usefulness expires • Expenses are also called expired costs Copyright © Houghton Mifflin Company. All rights reserved. 3– 11
Income Measurement Issues • Objective 2 – Explain how the income measurement issues of accounting period, continuity, and matching are resolved Copyright © Houghton Mifflin Company. All rights reserved. 3– 12
Income Measurement Issues • Accounting period issue (Periodicity) • Continuity issue • Matching issue Copyright © Houghton Mifflin Company. All rights reserved. 3– 13
The Accounting Period Issue • Addresses the difficulty of assigning revenues and expenses to a short period of time • Problem: – Some transactions have effects that extend over long periods of time (more than one accounting period) • Solution: – Make 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 entity’s profitability for the period Copyright © Houghton Mifflin Company. All rights reserved. 3– 14
The Accounting Period • A specific length of time during which the financial results of business transactions are recorded and measured • Time periods are of equal length to make comparisons easier • Financial statements may be prepared for any time period Copyright © Houghton Mifflin Company. All rights reserved. 3– 15
The Accounting Period (cont’d) • Fiscal year – Twelve-month accounting period used by an organization • Businesses can use the calendar year • Or, their fiscal year can correspond to the yearly activity of the business cycle • The fiscal year used should always be noted in the financial statements • Interim period – Accounting periods of less than one year • Usually a month or a quarter Copyright © Houghton Mifflin Company. All rights reserved. 3– 16
The Continuity Issue • The issue that arises when it is difficult to know how long a business entity will survive • Problem: – Certain revenue and expense transactions must be allocated over several accounting periods – Uncertainty exists about whether the business will continue to operate in the future • Solution: – The accountant assumes the business is a going concern • The business will continue to operate indefinitely, unless there is evidence to the contrary Copyright © Houghton Mifflin Company. All rights reserved. 3– 17
Assumption of Continuity • Justification for all the techniques of income measurement is based on the assumption of continuity (that a business is a going concern) – This allows the cost of certain assets to be held on the balance sheet until a future year, when they will become expenses on the income statement – The value of assets is recorded at cost and does not change for a going concern • For a business facing bankruptcy, there is no assumption of continuity, and assets may be reported at liquidation value (what they will bring in cash if sold) Copyright © Houghton Mifflin Company. All rights reserved. 3– 18
The Cash Basis of Accounting • Revenues are recorded when cash is received • Expenses are recorded when cash is paid • Problems associated with cash accounting – Revenues can be earned in a period other than the one in which cash is received – Expenses can be incurred in an accounting period other than the one in which cash is paid Copyright © Houghton Mifflin Company. All rights reserved. 3– 19
The Matching Issue • The difficulty of assigning revenues and expenses to the appropriate accounting period so that net income is measured accurately • Problem: – Revenues can be earned in a period other than the one in which cash is received – Expenses can be incurred in a period other than the one in which cash is paid • Solution: – The matching rule • Assign revenues to the accounting period in which the goods are sold or services are rendered • Assign expenses to the accounting period in which they are used to produce income Copyright © Houghton Mifflin Company. All rights reserved. 3– 20
The Matching Rule • Applying the matching rule solves the problems associated with cash basis accounting – Revenues and related expenses are recognized in the same accounting period • A building is converted from an asset to an expense by allocating its cost over the years the company benefits from its use • The cost of the building is expensed over a number of accounting periods, thereby matching its cost for each period with the revenues produced during each of those periods Copyright © Houghton Mifflin Company. All rights reserved. 3– 21
Discussion Q. Why does the need for an accounting period cause problems? – Any measurement of net income over a short period of time is tentative – Not all transactions can be easily assigned to specific periods – It is necessary to recognize that net income for any period less than the life of the business is a useful approximation of the net income for the period Copyright © Houghton Mifflin Company. All rights reserved. 3– 22
Accrual Accounting • Objective 3 – Define accrual accounting and explain two broad ways of accomplishing it Copyright © Houghton Mifflin Company. All rights reserved. 3– 23
Accrual Accounting … is the attempt to record the financial effects of transactions and other events in the periods in which they occur rather than only in the periods in which cash is received or paid Copyright © Houghton Mifflin Company. All rights reserved. 3– 24
Accrual Accounting (cont’d) • Developed to apply the matching rule by – Recording revenues when earned – Recording expenses when incurred – Adjusting the accounts Copyright © Houghton Mifflin Company. All rights reserved. 3– 25
Revenue Recognition • The process of determining when revenue is earned and when it should be recorded • Four criteria for revenue recognition established by the Securities and Exchange Commission (SEC) 1. Persuasive evidence of an arrangement 2. Delivery has occurred or services have been rendered 3. The seller’s price to the buyer is fixed or determinable 4. Reasonable assurance that the amount is collectable Copyright © Houghton Mifflin Company. All rights reserved. 3– 26
Revenue Recognition Example • Joan Miller Advertising Agency bills a customer for placing an advertisement 1. It is agreed customer owes for service 2. Services have been rendered 3. The seller’s price to the buyer is fixed or determinable 4. Collectibility is reasonably assured • The transaction should be recorded as revenue even though cash has not been received because all four criteria have been met • Record by – Debiting Accounts Receivable – Crediting Advertising Fees Earned Copyright © Houghton Mifflin Company. All rights reserved. 3– 27
Recognizing Expenses When Incurred • Same criteria apply as for revenue recognition • Criteria for recognizing expenses 1. An agreement exists to purchase a product or service 2. The product has been delivered or services rendered 3. A price is established or can be determined 4. The product or service has been used to produce revenue Copyright © Houghton Mifflin Company. All rights reserved. 3– 28
Example of Recognizing an Expense • Joan Miller Advertising Agency receives its telephone bill 1. It is agreed that Joan Miller Advertising owes for the service 2. Services have been rendered 3. A price is established or can be determined 4. The service has been used to produce revenue • The transaction should be recorded as an expense even though cash has not yet been paid because all four criteria have been met • Record by – Debiting Telephone Expense – Crediting Accounts Payable Copyright © Houghton Mifflin Company. All rights reserved. 3– 29
Adjusting the Accounts • Although operating a business is a continuous process, there must be a cutoff point for periodic reports – Reports are prepared at the end of an accounting period • Balance sheet must list all assets and liabilities at the end of the accounting period • Income statement must list all revenues and expenses applicable to the accounting period • Some transactions span more than one accounting period • These transactions require adjustments Copyright © Houghton Mifflin Company. All rights reserved. 3– 30
Adjusting the Accounts (cont. ) Some accounts in the end-of-period trial balance for Joan Miller Advertising Agency do not show the correct balances for preparing the financial statements The balance in Prepaid Rent represents rent for July and August. An adjustment is needed to reflect the proper balance of $800 and to allocate $800 to rent expense Copyright © Houghton Mifflin Company. All rights reserved. 3– 31
Accrual Accounting and Performance Measures • Importance of adjustments – They are necessary for determining key profitability performance measures because they affect • Net income on the income statement – Profitability comparisons from one period to another • Assets and liabilities on the balance sheet – Provide information about a company’s future cash inflows and outflows » Information needed to assess management’s shortterm goal of liquidity so that there is enough cash to pay bills Copyright © Houghton Mifflin Company. All rights reserved. 3– 32
Adjusting Entries • Never affect the Cash account – Therefore, they never affect cash flows in the current period – They do provide information about future cash flows • Accounts Receivable indicates expected future cash inflows • Accounts Payable indicates expected future cash outflows • Considerable judgment underlies the application of adjusting entries – Therefore, the potential for abuse exists – Misuse can result in misleading performance measures Copyright © Houghton Mifflin Company. All rights reserved. 3– 33
Adjustment’s Effect on the Income Statement and Balance Sheet Joan Miller Advertising Agency’s July 31 trial balance showed a balance of $1, 600 in the Prepaid Rent account July 2: Paid $1, 600 rent in advance for July and August July 31: Prepaid rent of $800 has expired. Adjust account by allocating $800 of prepaid rent to rent expense Prepaid Rent July 2 Bal. 1, 600 July 31 Rent Expense 800 July 31 800 The correct account balance of $800 will now be reflected on the balance sheet The correct account balance of $800 will now be reflected on the income statement If this adjustment was not made, assets on the balance sheet would be $800 too high and expenses on the income statement would be $800 too low Copyright © Houghton Mifflin Company. All rights reserved. 3– 34
Discussion Q. Why don’t adjustments ever involve the Cash account? A. Adjustments involve deferrals and accruals • Deferrals are the recognition of an expense already paid or a revenue received in advance – • Cash was recorded in a previous transaction when the cash was paid or received Accruals are the recognition of revenues or expenses that have arisen but have not yet been recorded because the related cash has not been received or paid – Cash will be recorded in a future transaction when it is received or paid Copyright © Houghton Mifflin Company. All rights reserved. 3– 35
The Adjustment Process • Objective 4 – State four principal situations that require adjusting entries and prepare typical adjusting entries Copyright © Houghton Mifflin Company. All rights reserved. 3– 36
Adjusting Entries … are used to apply accrual accounting to transactions that span more than one accounting period • Each adjusting entry must – Include at least one balance sheet account – Include at least one income statement account – Never include the Cash account Copyright © Houghton Mifflin Company. All rights reserved. 3– 37
When to Make Adjustments • Adjusting entries are required when – Recorded costs are allocated between two or more accounting periods – Expenses are incurred but not yet recorded – Recorded unearned revenues are allocated between two or more accounting periods – Revenues are earned but not yet recorded Copyright © Houghton Mifflin Company. All rights reserved. 3– 38
Four Types of Adjustments (Deferred Expenses) Also called deferred expenses or prepaid expenses Examples of recorded costs: Prepaid Rent Prepaid Insurance Supplies Equipment Building They represent expenses paid in advance that have not expired yet • Recorded costs are assets • Once a recorded cost expires it becomes an expense • The adjusting entry involves an asset account and an expense account Copyright © Houghton Mifflin Company. All rights reserved. 3– 39
Four Types of Adjustments (Deferred Expenses) (Accrued Expenses) Also called accrued expenses Example: Wages earned by employees in the current accounting period but after the last pay period • These expenses have been incurred and must be recorded as liabilities to the company • The adjusting entry involves an expense account and a liability account Copyright © Houghton Mifflin Company. All rights reserved. 3– 40
Four Types of Adjustments An example of recorded unearned revenue is Unearned Art Fees (Deferred Expenses) Also called deferred revenues (Accrued Expenses) (Deferred Revenues) It represents fees that have been received and recorded for services not yet provided • Recorded unearned revenues are liabilities • Once earned, recorded unearned revenue becomes revenue • The adjusting entry involves a liability account and a revenue account Copyright © Houghton Mifflin Company. All rights reserved. 3– 41
Four Types of Adjustments (Deferred Expenses) Also called accrued revenues (Accrued Revenues) (Accrued Expenses) Example: Advertising services that have been performed but no fees have been collected and the customer has not yet been billed (Deferred Revenues) • These revenues have been earned and must be recorded as assets to the company • The adjusting entry involves an asset account and a revenue account Copyright © Houghton Mifflin Company. All rights reserved. 3– 42
Four Types of Adjustments (Deferred Expenses) (Accrued Revenues) Copyright © Houghton Mifflin Company. All rights reserved. (Accrued Expenses) Notice that each adjusting entry involves one balance sheet account and one income statement account (Deferred Revenues) 3– 43
Deferrals • A deferral is the postponement of – The recognition of an expense already paid • Type 1 adjustment – The recognition of a revenue received in advance • Type 3 adjustment Copyright © Houghton Mifflin Company. All rights reserved. 3– 44
Accruals • An accrual is the recognition of – A revenue that has arisen but has not yet been recorded • Cash will be received in a future period • Type 4 adjustment – An expense that has arisen but has not yet been recorded • Cash will be paid in a future period • Type 2 adjustment Copyright © Houghton Mifflin Company. All rights reserved. 3– 45
Deferred Expenses • The postponement of the recognition of expenses already paid • Require allocating recorded costs between two or more accounting periods – Recorded costs • Expenditures that benefit more than one accounting period • Usually debited to an asset account • At the end of the accounting period the amount that has been used is transferred to an expense account • Prepaid expenses and depreciation of plant and equipment are two types of adjustments involving deferred expenses Copyright © Houghton Mifflin Company. All rights reserved. 3– 46
Prepaid Expenses • Expenses paid in advance that have not yet expired • Are recorded as assets • A certain portion expires at the end of an accounting period • An adjusting entry is made to reduce the asset and increase the expense – The amount of the adjustment equals the cost of goods or services used up or expired – If adjustments for prepaid expenses are not made at the end of the accounting period • • Assets will be overstated Expenses will be understated Owner's equity will be overstated Net income will be overstated Copyright © Houghton Mifflin Company. All rights reserved. 3– 47
Prepaid Rent July 2: Joan Miller Advertising Agency paid $1, 600 rent in advance for July and August • As each day of the month passes, part of the asset, prepaid rent, expires and becomes an expense • By July 31, half of the prepaid rent has expired and should be treated as an expense July 31: Prepaid rent of $800 has expired for July. Adjust account by allocating $800 of Prepaid Rent to Rent Expense Prepaid Rent July 2 1, 600 Copyright © Houghton Mifflin Company. All rights reserved. 3– 48
Prepaid Rent Adjusting Transaction July 31: Expiration of one month’s rent, $800 Step 1 Analyze Decrease in owner's equity (increase in expenses) Decrease in assets Step 2 Debits decrease owner's equity (increase Rent Expense) Apply rules Credits decrease assets (Prepaid Rent) Step 3 Record Balance sheet account Prepaid Rent July 2 Bal. Income statement account Rent Expense 1, 600 July 31 800 800 The Prepaid Rent account now reflects $800 of rent paid in advance for August Copyright © Houghton Mifflin Company. All rights reserved. The Rent Expense account now reflects $800 of rent expense for July 3– 49
Prepaid Insurance July 8: The Agency purchased a one-year life insurance policy in advance, $960 • As each day of the month passes, part of the asset, prepaid insurance, expires and becomes an expense • By July 31, one month, or one-twelfth, of the prepaid rent has expired and should be treated as an expense July 31: Prepaid insurance of $80 has expired for July. Adjust the account by allocating $80 of Prepaid Insurance to Insurance Expense Prepaid Insurance July 8 960 Copyright © Houghton Mifflin Company. All rights reserved. 3– 50
Prepaid Insurance Adjusting Transaction July 31: Expiration of one month’s life insurance, $80 Step 1 Analyze Decrease in owner's equity (increase in expenses) Decrease in assets Step 2 Apply rules Debits decrease owner's equity (increase Insurance Expense) Credits decrease assets (Prepaid Insurance) Step 3 Record Income statement account Balance sheet account Prepaid Insurance July 8 960 July 31 Bal. Insurance Expense 880 The Prepaid Insurance account now reflects $880 of insurance paid in advance for 11 months Copyright © Houghton Mifflin Company. All rights reserved. 80 July 31 80 The Insurance Expense account now reflects $80 of insurance expense for July 3– 51
Art and Office Supplies • Earlier in the month, Joan Miller Advertising Agency purchased art supplies • As advertising designs for clients were prepared, art supplies were consumed • Inventory is taken at the end of the month to determine supplies on hand • The amount of art supplies consumed during the month is calculated an adjustment is made • Repeat procedure to determine office supplies expense Copyright © Houghton Mifflin Company. All rights reserved. 3– 52
Art Supplies July 6: The Agency purchased $1, 800 of art supplies • Ending inventory shows $1, 300 of art supplies still on hand • This means that of the $1, 800 of art supplies originally purchased, $500 worth were consumed (became an expense) July 31: Art supplies worth $500 were consumed during July. Adjust account by allocating $500 of Art Supplies to Art Supplies Expense Art Supplies July 6 1, 800 Bal. 1, 300 Copyright © Houghton Mifflin Company. All rights reserved. 3– 53
Art Supplies Adjusting Transaction July 31: Consumption of $500 worth of art supplies Step 1 Analyze Decrease in owner's equity (increase in expenses) Decrease in assets Step 2 Debits decrease owner's equity (increase Art Supplies Expense) Apply rules Credits decrease assets (Art Supplies) Step 3 Record Balance sheet account Art Supplies July 6 1, 800 July 31 Bal. Income statement account Art Supplies Expense 1, 300 The Art Supplies account now reflects $1, 300 of art supplies still on hand Copyright © Houghton Mifflin Company. All rights reserved. 500 July 31 500 The Art Supplies Expense account now reflects the $500 of art supplies consumed during July 3– 54
Office Supplies July 6: The Agency purchased $800 of office supplies • Ending inventory shows $600 of office supplies still on hand • This means that of the $800 of office supplies originally purchased, $200 worth were consumed (became an expense) July 31: Office supplies worth $200 were consumed during July. Adjust account by allocating $200 of Office Supplies to Office Supplies Expense Office Supplies July 6 800 Bal. 600 Copyright © Houghton Mifflin Company. All rights reserved. 3– 55
Office Supplies Adjusting Transaction July 31: Consumption of $200 worth of office supplies Step 1 Analyze Decrease in owner's equity (increase in expenses) Decrease in assets Step 2 Debits decrease owner's equity (increase Office Supplies Apply rules Expense) Credits decrease assets (Office Supplies) Step 3 Record Balance sheet account Income statement account Office Supplies Expense July 6 800 July 31 Bal. 600 The Office Supplies account now reflects $500 of art supplies still on hand Copyright © Houghton Mifflin Company. All rights reserved. 200 July 31 200 The Office Supplies Expense account now reflects the $200 of office supplies consumed during July 3– 56
Depreciation … is the periodic allocation of the cost of a tangible asset over its estimated useful life • When a long-term asset is purchased, the company is paying in advance for the usefulness of the asset for as long as it benefits the company • This purchase of an asset is a deferral of an expense • The cost of the asset must be allocated over its estimated useful life • The amount allocated to any one period is called depreciation, or depreciation expense Copyright © Houghton Mifflin Company. All rights reserved. 3– 57
Depreciation (cont’d) • Is an expense • Is incurred during an accounting period to produce revenue • Must be estimated – The useful life of the asset is estimated – The cost of the asset and its estimated useful life are used to determine the amount expensed each month – A number of methods exist for determining depreciation • Depreciation expense does not reduce the asset account directly, but is recorded in a contra account Copyright © Houghton Mifflin Company. All rights reserved. 3– 58
Contra Account • A separate account paired with the asset account • Used to show the accumulated amount of depreciation expensed for the related asset • The balance in the contra account is shown on the financial statements as a deduction from the related asset account • Contra accounts are used to – Recognize that depreciation is an estimate – Preserve the original cost of the asset • In combination with the asset account, they show – How much of the asset has been allocated as an expense – The balance left to be depreciated Copyright © Houghton Mifflin Company. All rights reserved. 3– 59
Depreciation of Art Equipment July 3: Joan Miller Advertising Agency paid $4, 200 for art equipment • As each day of the month passes, the asset, art equipment, is used to produce revenue • As a result, part of its cost expires and becomes an expense • By July 31, $70 of its cost should be treated as an expense July 31: Depreciate art equipment for July. Record $70 of depreciation expense Art Equipment July 3 4, 200 Copyright © Houghton Mifflin Company. All rights reserved. Because depreciation is recorded in a contra account, the adjusting entry to record depreciation will not involve the Art Equipment account 3– 60
Depreciation of Art Equipment Adjusting Transaction July 31: Record depreciation expense for art equipment, $70 Decrease in owner's equity (increase in expenses) Decrease in assets (increase in contra asset) Step 1 Analyze Debits decrease owner's equity (increase Depreciation Step 2 Expense, Art Equipment) Apply rules Credits decrease assets (increase Accumulated Depreciation, Art Equipment) Step 3 Record Deprecation Exp. , Art Equip. July 31 70 Income statement account The Depreciation Expense account now reflects $70 of the cost of Art Equipment that has been expensed for July Copyright © Houghton Mifflin Company. All rights reserved. Accum. Depreciation, Art Equip. July 31 70 Balance sheet account The Accumulated Depreciation account now reflects the accumulated amount that the art equipment has been depreciated 3– 61
Depreciation of Office Equipment July 5: Joan Miller Advertising Agency paid $3, 000 for office equipment • As each day of the month passes, the asset, office equipment, is used to produce revenue • As a result, part of its cost expires and becomes an expense • By July 31, $50 of its cost should be treated as an expense July 31: Depreciate office equipment for July. Record $50 of depreciation expense Office Equipment July 5 3, 000 Copyright © Houghton Mifflin Company. All rights reserved. Because depreciation is recorded in a contra account, the adjusting entry to record depreciation will not involve the Office Equipment account 3– 62
Depreciation of Office Equipment Adjusting Transaction July 31: Record depreciation expense for office equipment, $50 Step 1 Analyze Decrease in owner's equity (increase in expenses) Decrease in assets (increase in contra asset) Debits decrease owner's equity (increase Depreciation Step 2 Expense, Office Equipment) Apply rules Credits decrease assets (increase Accumulated Depreciation, Office Equipment) Step 3 Record Deprecation Exp. , Office Equip. July 31 50 Accum. Depreciation, Office Equip. July 31 50 Income statement account Balance sheet account The Depreciation Expense account now reflects $50 of the cost of Office Equipment that has been expensed for July The Accumulated Depreciation account now reflects the accumulated amount that the office equipment has been depreciated Copyright © Houghton Mifflin Company. All rights reserved. 3– 63
Carrying Value of Assets • Carrying value is the portion of the cost of an asset that has not yet expired (been expensed) • Also called book value Carrying value = Cost – Accumulated Depreciation Compute the carrying value of art equipment for Joan Miller Advertising Agency Carrying value = $4, 200 – $70 = $4, 130 At the end of August, depreciation expense of $70 will be recorded again Carrying value = $4, 200 – $140 = $4, 060 Art Equipment July 3 4, 200 Accum. Depreciation, Art Equip. July 31 Aug 31 Bal. Copyright © Houghton Mifflin Company. All rights reserved. 70 70 140 3– 64
Accrued Expenses • Expenses that are incurred but not yet recorded • At the end of the accounting period the amount that has been incurred is recorded in – An expense account – The corresponding liability account • As the expense and liability accumulate, they are said to accrue • Common unrecorded (accrued) expenses – – Interest Taxes Wages Utilities Copyright © Houghton Mifflin Company. All rights reserved. 3– 65
Accrued Wages • The pay period for the secretary at Joan Miller Advertising Agency is biweekly (every two weeks) • The last pay period ended July 26 • At the end of business on July 31, the secretary has earned 3 days wages but will not be paid until the next payday in August • These wages are an expense for July and should be recorded as a liability to the company Su M July Tu W Th Sa 5 6 1 7 4 F 2 3 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31
Calculating Accrued Wages • The secretary’s wage rate is equal to $1, 200 every two weeks • Calculate wages payable as of July 31 Copyright © Houghton Mifflin Company. All rights reserved. 3– 67
Accrued Wages Adjusting Transaction July 31: Accrual of unrecorded wages expense for July of $360 Step 1 Analyze Increase in liabilities Decrease in owner's equity (increase in expenses) Step 2 Debits decrease owner's equity (increase Wages Expense) Apply rules Credits increase liabilities (Wages Payable) Step 3 Record Income statement account Wages Expense July 31 Balance sheet account Wages Payable 360 The Wages Expense account now reflects $360 of accrued wages for July Copyright © Houghton Mifflin Company. All rights reserved. July 31 360 The Wages Payable account now reflects the liability that exists to pay wages for July 3– 68
Estimated Income Taxes • Joan Miller Advertising Agency is a corporation subject to federal income taxes • Actual amount owed will not be known until the end of the year • Income tax expense for each month is estimated • Joan Miller estimates that July’s share of federal income taxes for the year is $400 Copyright © Houghton Mifflin Company. All rights reserved. 3– 69
Estimated Income Taxes Adjusting Transaction July 31: Accrual of estimated income taxes for July, $400 Increase in liabilities Decrease in owner's equity (increase in expenses) Step 1 Analyze Debits decrease owner's equity (increase Income Taxes Step 2 Expense) Apply rules Credits increase liabilities (Income Taxes Payable) Step 3 Record Income statement account Income Taxes Expense July 31 400 The Income Taxes Expense account now reflects $400 of accrued income taxes for July Copyright © Houghton Mifflin Company. All rights reserved. Balance sheet account Income Taxes Payable July 31 400 The Income Taxes Payable account now reflects the liability that exists to pay income taxes for July 3– 70
Deferred Revenues • The postponement of the recognition of revenues already received • Require allocating recorded unearned revenues between two or more accounting periods – Recorded unearned revenue • Revenues that are received in advance (creating a liability) • Deferred revenues are credited to a liability account • At the end of the accounting period the amount that has been earned is transferred to a revenue account Copyright © Houghton Mifflin Company. All rights reserved. 3– 71
Unearned Art Fees July 15: The Joan Miller Advertising Agency received payment in advance for advertising designs for another agency, $1, 000 • By the end of July, $400 worth of designs had been finished and accepted by the other agency July 31: Services for which payment was received in advance were partially performed. The revenue has been earned and must be recognized Unearned Art Fees July 15 1, 000 Copyright © Houghton Mifflin Company. All rights reserved. 3– 72
Unearned Art Fees Adjusting Transaction July 31: Performance of services paid for in advance, $400 Step 1 Analyze Decrease in liabilities Increase in owner's equity Step 2 Debits decrease liabilities (Unearned Art Fees) Apply rules Credits increase stockholder’s equity (Art Fees Earned) Step 3 Record Balance sheet account Unearned Art Fees July 31 Income statement account Art Fees Earned 400 July 15 1, 000 Bal. 400 600 The Unearned Art Fees account now reflects $600 of unearned art fees that remain at the end of July Copyright © Houghton Mifflin Company. All rights reserved. July 31 The Art Fees Earned account now reflects the revenue that was earned for July 3– 73
Accrued Revenues • Revenues earned but not yet recorded • At the end of the accounting period, record the amount that has been earned in – A revenue account • To record the amount of revenue that has been earned – The Accounts Receivable account (an asset account) • To record amounts due to the company for services performed Copyright © Houghton Mifflin Company. All rights reserved. 3– 74
Accrued Advertising Fees Adjusting Transaction July 31: Accrual of unrecorded revenue for July of $200 Step 1 Analyze Increase in assets Increase in owner's equity Step 2 Debits increase assets (Accounts Receivable) Apply rules Credits increase owner's equity (Advertising Fees Earned) Step 3 Record Income statement account Accounts Receivable July 31 200 The Accounts Receivable account now reflects $200 of accrued advertising fees for July Copyright © Houghton Mifflin Company. All rights reserved. Balance sheet account Advertising Fees Earned July 31 400 The Advertising Fees Earned account now reflects the revenue that was earned for July 3– 75
Discussion Q. What do plant and equipment, office supplies, and prepaid insurance have in common? – They are all assets – Their cost must be allocated to expenses as they are used over time – They all require adjusting entries at the end of the accounting period Copyright © Houghton Mifflin Company. All rights reserved. 3– 76
Using the Adjusted Trial Balance to Prepare Financial Statements • Objective 5 – Prepare financial statements from an adjusted trial balance Copyright © Houghton Mifflin Company. All rights reserved. 3– 77
Adjusted Trial Balance • A trial balance prepared after all adjusting entries have been recorded and posted to the accounts • Total debits = total credits • The financial statements can easily be prepared from the adjusted trial balance Copyright © Houghton Mifflin Company. All rights reserved. 3– 78
Sequence for Preparing Financial Statements 1. Income statement – Uses revenue and expense accounts from adjusted trial balance 2. Statement of owner’s equity – Uses Capital account balance from adjusted trial balance – Uses net income from the income statement 3. Balance sheet – Uses balance sheet accounts from adjusted trial balance – Uses end of period balance in Capital account from statement of owner’s equity Copyright © Houghton Mifflin Company. All rights reserved. 3– 79
Sequence for Preparing Financial Statements The Capital account balance on the adjusted trial balance is the beginning of period balance — the end of period balance is calculated in the statement of owner’s equity Copyright © Houghton Mifflin Company. All rights reserved. 3– 80
Discussion Q. Where does unearned revenue appear on the balance sheet? A. Unearned revenue appears as a liability on the balance sheet Copyright © Houghton Mifflin Company. All rights reserved. 3– 81
Cash Flows from Accrual-Based Information • Objective 6 – Analyze cash flows from accrual-based information Copyright © Houghton Mifflin Company. All rights reserved. 3– 82
Cash Flows from Accrual-Based Information • Every revenue or expense account on the income statement has one or more related accounts on the balance sheet • These accounts are related through adjusting entries – Adjusting entries are based on accrual accounting • Cash flows generated or paid by company operations can be determined by analyzing these relationships Copyright © Houghton Mifflin Company. All rights reserved. 3– 83
Determining Cash Flows General Rule Note: The general rule does not apply to depreciation Copyright © Houghton Mifflin Company. All rights reserved. 3– 84
Applying the General Rule Application of the general rule varies with the type of asset or liability account • For deferrals – Prepaid expenses • Ending Balance + Expense for the Period – Beginning Balance – Unearned revenues • Ending Balance + Revenue for the Period – Beginning Balance • For accruals – Accrued expenses • Beginning Balance + Expense for the Period – Ending Balance – Accrued revenues • Beginning Balance + Revenue for the Period – Ending Balance Copyright © Houghton Mifflin Company. All rights reserved. 3– 85
Cash Payments for Insurance Deferred expense Prepaid Insurance Cash 310 May 31 480 120 310 Jun 30 670 General rule for deferred expenses Cash payments for expenses The beginning balance is deducted because it was paid in a prior period Insurance Expense 120
Another Example of Determining Cash Flows from Accrual-Based Information Determine Joan Miller Advertising Agency’s cash payments for wages for the month of July Copyright © Houghton Mifflin Company. All rights reserved. 3– 87
Cash Payments for Wages Accrued expense Cash Wages Payable 2, 400 July 12 1, 200 26 1, 200 31 360 July 31 360 Wages Expense July 12 1, 200 26 1, 200 31 360 July 31 2, 760 General rule for accrued expenses Cash payments for expenses The beginning balance is zero because July is the first month of operation The ending balance is deducted because it has not yet been paid
Discussion Q. Why is the income statement the first statement prepared from the adjusted trial balance? – The net income figure is needed to complete the statement of retained earnings – The end of period balance for retained earnings is then needed to prepare the owner's equity section of the balance sheet Copyright © Houghton Mifflin Company. All rights reserved. 3– 89
Time for Review 1. Define net income and its two major components, revenues and expenses 2. Explain how the income measurement issues of accounting period, continuity, and matching are resolved 3. Define accrual accounting and explain two broad ways of accomplishing it Copyright © Houghton Mifflin Company. All rights reserved. 3– 90
And Finally… 4. State four principal situations that require adjusting entries and prepare typical adjusting entries 5. Prepare financial statements from an adjusted trial balance 6. Analyze cash flows from accrual-based information Copyright © Houghton Mifflin Company. All rights reserved. 3– 91
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