Finanacial Accounting Ch3

Financial Accounting
Belverd E. Needles, Jr. Marian Powers

----------Multimedia Slides by: Dr. Howard A. Kanter, CPA
DePaul University
Milton M. Pressley
University of New Orleans
Copyright2001 by Houghton Mifflin Company. All rights reserved. 1
Chapter 3 Measuring Business Income

Belverd E. Needles, Jr. Marian Powers
----------Multimedia Slides by: Dr. Howard A. Kanter, CPA
DePaul University
Milton M. Pressley
University of New Orleans
LEARNING OBJECTIVES
1. Define net income and 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 accounting and explain two broad ways of accomplishing it.
Copyright2001 by Houghton Mifflin Company. All rights reserved.
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.
Supplemental Objectives
Analyze cash flows from accrualbased information.
Profitability Measurement: The Role of Business Income
Objective 1
Define net income and its two major components, revenues and expenses.
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 income is the preferred term because it can be defined more precisely from an accounting point of view.
Net Income
Net income is the net increase in stockholders equity that results from the operations of a company. Net income is accumulated in the Retained Earnings account. Net Income = Revenues - Expenses. R > E, net profit. R < E, net loss.

Revenues
Revenues are
increases in SE 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. Stockholders investments increase SE but are not revenues.
Expenses
are decreases in SE 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 SE arise from expenses. Dividends are not expenses.
Expenses
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 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 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 interim periods. The fiscal 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
The Continuity Issue
Objective 2b
Explain the difficulties of income measurement caused by the continuity issue.
14
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 entitys life. The accountant assumes that an entity is a going concern, that the entity 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.
The Matching Issue
Objective 2c
Explain the difficulties of income measurement caused by the matching issue.
16
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.
Accrual Accounting
Objective 3
Define accrual accounting and explain two broad ways of accomplishing it.
18
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.
Accrual accounting
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.
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.
21
The Adjustment Process
Objective 4
State four principal situations that require adjusting entries.
22
The Adjustment Process

Adjusting
entries are 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.
23
Four Types of Adjusting Entries

1. Costs have been recorded that must be allocated between two or more accounting periods. 2. Expenses have been incurred but are not yet recorded. 3. Revenues have been recorded that must be allocated between two or more accounting periods. 4. Revenues have been earned but not yet recorded.
24
Deferrals
A deferral is the postponement of:

The recognition of an expense already paid (Type 1 adjustment), or A revenue received in advance (Type 3 adjustment).
25
Accruals
An
accrual is the recognition of a revenue (Type 4 adjustment) or expense (Type 2 adjustment) that has arisen but has not yet been recorded.
26
Allocating Recorded Costs Between Two or More Accounting Periods
Objective 5
Prepare typical adjusting entries.
27
Type 1: Allocating
Deferred Expenses Prepaid Expenses: Rent Expense

Dr. 400 Cr. 400
Jan. 31 Rent Expense Prepaid Rent Prepaid Rent Jan. 2 800 Jan. 31
400
Transaction Analysis
Rent Expense Jan. 31 400
Rules Entry
28
Type 1: Allocating Deferred Expenses Prepaid Expenses: Insurance Expense
Jan. 31 Insurance Expense Prepaid Insurance Prepaid Insurance 480 Jan. 31 Insurance Expense Jan. 31 40
Dr. 40
Cr. 40
Jan. 8
40
Transaction Analysis Rules Entry
29
Type 1: Allocating Deferred Expenses

Prepaid Expenses: Art Supplies Expense
Dr. 500 Cr. 500
Jan. 31 Art Supplies Expense Art Supplies Art Supplies Jan. 6 1,800 Jan. 31
500
Art Supplies Expense Jan. 31 500
Rules Entry
30

Prepaid Expenses: Office Supplies
Jan. 31 Office Supplies Expense Office Supplies Office Supplies Jan. 6 800 Jan. 31 200 Transaction Analysis Office Supplies Expense Jan. 31 200 Entry
Dr. 200
Cr. 200
Rules
Adjustment for Prepaid (Deferred) Expenses
32

Depreciation of PP&E: Art Equipment
Dr. Jan. 31 Depreciation Expense, Art Equipment 70 Accumulated Depreciation, Art Equipment Accumulated Deprn, Art Equipment Jan. 31 70 Transaction Analysis Depreciation Expense, Art Equipment Jan. 31 70 Entry
Cr. 70
Rules

Depreciation of PP&E: Office Equipment
Dr. Jan. 31 Depreciation Expense, Office Equipment 50 Accumulated Depreciation, Office Equipment Accumulated Deprn, Office Equipment Jan. 31 50 Transaction Analysis Depreciation Expense, Office Equipment Jan. 31 50 Entry
Cr. 50
Rules
Adjustment for Depreciation
35
Type 2: Recognizing Unrecorded (Accrued)

Expenses Accrued Expenses: Accrued Wages
Jan. 31 Wages Expense Wages Payable Wages Payable Jan. 31 Wages Expense 600 600 180
Dr. 180
Cr. 180
180
Jan. 12 26 31
Rules Entry
36

Expenses Accrued Expenses: Estimated Income Taxes
Dr. Jan. 31 Income Taxes Expense Income Taxes Payable Income Taxes Payable Jan. 31 400 Transaction Analysis Income Taxes Expense Jan. 31 400 Entry
Cr. 400
400
Rules
Adjustment for Unrecorded (Accrued) Expenses
38
Type 3: Allocating Deferred Revenues

Deferred Revenues: Unearned Fees
Dr. 400 Cr. 400
Jan. 31 Unearned Art Fees Art Fees Earned Unearned Art Fees Jan. 31 400 Jan. 15 1,000
Art Fees Earned Jan. 31

Rules 400 Entry

39
Adjustment for Unearned (Deferred) Revenues
40

Revenues Accrued Revenues: Advertising Fees
Dr. 200 Cr. 200
Jan. 31 Fees Receivable Advertising Fees Earned Fees Receivable Jan. 31 200
Advertising Fees Earned Jan. 10 19 31 1,400 2,800 200
Rules Entry
41
Adjustment for Unrecorded (Accrued) Revenues
42
Using the Adjusted Trial Balance to Prepare Financial Statements
Objective 6
Prepare financial statements from an adjusted trial balance.
43
The Adjusted Trial Balance (ATB)

ATB is prepared after adjusting entries have been recorded and posted. The ATB is a listing of all accounts and their balances. The ATB should have equal debits and credits. Financial statements are prepared from the ATB by copying the appropriate accounts to the appropriate financial statement.
The
Cash Flows, Accrual Accounting, and Management Objectives
Supplemental Objective 7
Analyze cash flows from accrual-based information.
45
Cash Flows from Accrual-Based AccrualInformation
1. Management has a liquidity
goal, which is measured by cash flow.
46
2. Every revenue or expense account on the income statement has one or more related accounts on the balance sheet.
Supplies is related to Supplies Expense. Wages Expense is related to Wages Payable.
3. Cash flows generated or paid by company operations may also be determined by analyzing these relationships. 4. The following rules may be applied to determine cash flow.
Prepaid Expense Ending balance + Expense for the period - Beginning balance = Cash payments for expenses. Unearned Revenue Ending balance + Revenue for the period - Beginning balance = Cash receipts from revenues.
Accrued Expense
Beginning balance + Expense for the period - Ending balance = Cash payments for expenses.
Accrued Revenue
Beginning balance + Revenue for period - Ending balance = Cash receipts from revenues.
OKAY, LETS REVIEW...

1. Define net income and 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 accounting and explain two broad ways of accomplishing it.
AND FINALLY...
4. State four principal situations that require adjusting entries. 5. Prepare typical adjusting entries. 6. Prepare financial statements from an adjusted trial balance. 7. Analyze cash flows from accrualbased information.
51

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Financial Accounting

Belverd E. Needles, Jr. Marian Powers

Chapter 3 Measuring Business Income

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Analyze cash flows from accrualbased information.

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Profitability Measurement: The Role of Business Income

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Profitability Measurement: The Role of Business Income

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Accounting Period Issue

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Accounting Period Issue

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Measurement of Business Income

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Continuity Issue

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Continuity Issue

The Matching Issue

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Matching Issue

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Implementation of Accrual Accounting

2. By adjusting the accounts.

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Adjustment Process

Copyright2001 by Houghton Mifflin Company. All rights reserved.

The Adjustment Process

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Four Types of Adjusting Entries

Copyright2001 by Houghton Mifflin Company. All rights reserved.

A deferral is the postponement of:

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Allocating Recorded Costs Between Two or More Accounting Periods

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Deferred Expenses Prepaid Expenses: Rent Expense

Rent Expense Jan. 31 400

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Type 1: Allocating Deferred Expenses Prepaid Expenses: Insurance Expense

Transaction Analysis Rules Entry

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Type 1: Allocating Deferred Expenses

Art Supplies Expense Jan. 31 500

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Type 1: Allocating Deferred Expenses

Adjustment for Prepaid (Deferred) Expenses

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Type 1: Allocating Deferred Expenses

Type 1: Allocating Deferred Expenses

Adjustment for Depreciation

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Type 2: Recognizing Unrecorded (Accrued)

Type 2: Recognizing Unrecorded (Accrued)

Adjustment for Unrecorded (Accrued) Expenses

Copyright2001 by Houghton Mifflin Company. All rights reserved.

Type 3: Allocating Deferred Revenues

Art Fees Earned Jan. 31

Rules 400 Entry

Adjustment for Unearned (Deferred) Revenues

Copyright2001 by Houghton Mifflin Company. All rights reserved.