Download Expenses

Chapter 3
Measuring Business Income
3–1
Why Must a Business Be Profitable?
Profitability is a major goal of a business.
Profit must be attainedTo succeed
To survive
To increase stockholders’ equity
To demonstrate positive performance
Accountants use the term net income when
referring to profitability
Copyright © Cengage Learning. All rights reserved.
3–2
Net Income
Net Income = Revenues – Expenses
Net increase in stockholders’ equity
resulting from operations
Retained Earnings
Net income is
accumulated
here
© Royalty-Free/Corbis
If expenses exceed revenues, a net loss occurs
Copyright © Cengage Learning. All rights reserved.
3–3
Revenues
Increases in stockholders’
equity resulting from…
 selling goods
 rendering services
 performing other business
activities
© Royalty Free Digital Vision/ Getty Images
Cash Received
Promise to Pay Received
(Accounts Receivable)
Copyright © Cengage Learning. All rights reserved.
3–4
Not all increases in cash or stockholders’
equity arise from 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
– Investments by Owners
Copyright © Cengage Learning. All rights reserved.
3-5
3–5
Expenses
Decreases in stockholders’ equity resulting
from the cost of…
 selling goods
 rendering services
 performing other business
activities
Cost of doing
business
 Salaries Expense
 Rent Expense
 Utilities Expense
 Depreciation of a building
Not all decreases in stockholders’ equity arise from expenses
(Example: Dividends)
Copyright © Cengage Learning. All rights reserved.
3–6
Expenses
Include
•Costs of Goods sold
•Activities necessary to carry on a business
Cost of doing
business
 Salaries Expense
 Rent Expense
 Utilities Expense
 Depreciation of a building
•Attracting and serving customers
Not all decreases in stockholders’ equity arise from expenses
(Example: Dividends)
Copyright © Cengage Learning. All rights reserved.
3–7
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
– Cash payments for dividends
• Decrease cash and increase Dividends
– Dividends is a stockholders’ equity account, not an expense
account
Copyright © Cengage Learning. All rights reserved.
3-8
3–8
What Assumptions Play A Role
in Income Measurement?
Continuity
What is the expected life of
the business?
Periodicity
Over what period of time
are transactions measured?
Matching
Are expenses assigned to
the period in which they are
used to generate revenue?
Copyright © Cengage Learning. All rights reserved.
3–9
Continuity
Measuring transactions requires that certain expenses and revenues
be allocated over several accounting periods.
Going Concern
Assumption
Unless there is evidence to the contrary, the accountant
assumes that the business will continue to operate indefinitely
Balance Sheet
The cost of
certain assets
may be held
until a future
year…
Copyright © Cengage Learning. All rights reserved.
Income
Statement
$
when it will
become an
expense.
3–10
Periodicity
• Addresses the difficulty of assigning revenues and
expenses to a specific period of time.
• Accountants make an assumption about periodicity:
– net income for any period of time less than the life of the
business is a useful estimate of the entity’s profitability
for the period.
• Time periods are of equal length to make
comparisons easier.
• Financial statements may be prepared for any time
period.
Copyright © Cengage Learning. All rights reserved.
3-11
3–11
Accounting Periods
• 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 quarter
Copyright © Cengage Learning. All rights reserved.
3-12
3–12
Matching
 Revenues should be assigned to the accounting
period in which the goods are sold or the
services performed
 Expenses must be assigned to the accounting
period in which they are used to produce
revenue
If cause and effect
relationship exists…
Recognize expenses and related
revenues in same period
If no cause and effect
relationship exists…
Allocate costs in a systematic way to
accounting periods that benefit from the
costs
Copyright © Cengage Learning. All rights reserved.
3–13
Cash Basis of Accounting
• Some businesses use the cash basis of
accounting, though it does not follow
the matching rule.
– Expenses are recorded when cash is paid.
– Revenues are recorded when cash is
received.
Copyright © Cengage Learning. All rights reserved.
3-14
3–14
Ethical Use of the Matching Rule
Applying the matching rule involves judgment
Example: Useful life of equipment is an estimate that should
be realistic and supportable
 Within reasonable range,
management has latitude
in making estimates
 Choices will affect net
income reported
If estimates move outside a
reasonable range, financial
statements become misleading.
Copyright © Cengage Learning. All rights reserved.
 Manipulation of revenues
and expenses to achieve
a specific outcome –
earnings management
 Not illegal, but not the
best practice
Fraudulent
financial
reporting
3–15
Assumptions and the Matching Rule
Copyright © Cengage Learning. All rights reserved.
3–16
Accrual Accounting
© Royalty Free PhotoDisc Collection/ Getty Images
Copyright © Cengage Learning. All rights reserved.
3–17
What Is Accrual Accounting?
Revenues and expenses are recorded in the
periods in which they occur rather than in the
periods when cash is received or paid
Accrual accounting is accomplished by:
Recording revenues when earned
Recording expenses when incurred
Adjusting the accounts
Copyright © Cengage Learning. All rights reserved.
3–18
How Do We Determine When
Revenue Should Be Recognized?
Revenue recognition process
The following conditions should be met:
 persuasive evidence of an arrangement exists
 delivery has occurred or services have been rendered
 seller’s price to buyer is fixed or determinable
 collectibility is reasonably assured
Copyright © Cengage Learning. All rights reserved.
3–19
When Should Expenses
Be Recognized?
Record when these conditions are met:
 agreement exists to
purchase goods or services
 goods have been delivered
or services rendered
 a price is established or
can be determined
 goods or services have
been used to produce
revenue
Copyright © Cengage Learning. All rights reserved.
© Royalty-Free/Corbis
3–20
Adjusting the Accounts
Adjustments are needed because accounts
need to be updated to the specific day that the
accounting period ends
Some transactions
span the cutoff date
Accounts must
contain all amounts
applicable to the
period
Copyright © Cengage Learning. All rights reserved.
© Royalty-Free/Corbis
3–21
Impact of Adjustments
 Do not affect cash flows because they never involve
the Cash account
 Affect assets, liabilities, revenues, and expenses
 Necessary to measure
profitability
 Affect profitability
comparisons from
one period to the
next
© Royalty Free C Squared Studios/ Getty Images
Copyright © Cengage Learning. All rights reserved.
3–22
The Adjustment Process
© Royalty-Free/Corbis
Copyright © Cengage Learning. All rights reserved.
3–23
Four Types of Adjustments
INCOME STATEMENT
BALANCE SHEET
Expense
Assets
Liabilities
1. Recorded costs are
allocated between
two or more
accounting periods
2. Expenses are
incurred but not yet
recorded
(Deferred Expenses)
Revenue
4. Revenues are
earned but not yet
recorded
(Accrued Revenues)
Copyright © Cengage Learning. All rights reserved.
(Accrued Expenses)
3. Recorded unearned
revenues are
allocated between
two or more
accounting periods
Notice that each
adjusting entry
involves one
balance sheet
account
and one income
statement
account
(Deferred Revenues)
3-24
3–24
Types of Adjusting Entries
Deferral – postponement of
1. Allocating recorded costs
recognition of an expense
between two or more
already paid or of revenue
accounting periods
received in advance
2. Recognizing
unrecorded expenses
Accrual – recognition of a
3. Allocating recorded,
revenue or expense that has
arisen but is unrecorded
unearned revenues
between two or more
accounting periods
4. Recognizing unrecorded, earned
revenues
Copyright © Cengage Learning. All rights reserved.
3–25
Type 1: Allocating Recorded Costs
 Expenditures often benefit more
than one period
 When first recorded, they are
usually debited to an asset account
 Amount consumed should be
transferred from the asset account
to an expense account
Two common kinds of adjustments
Prepaid Expenses
Depreciation of Plant and Equipment
Copyright © Cengage Learning. All rights reserved.
3–26
Prepaid Expenses
Expenses like rent,
insurance, and supplies
are often paid in advance
 When initially paid,
these expenses are
recorded in an asset
account
 The expired amount
should be transferred to
an expense account at
the end of the period
Copyright © Cengage Learning. All rights reserved.
© Royalty-Free/Corbis
3–27
Prepaid Rent Adjustment Illustrated
On July 3 Miller Design Studio paid two months’ rent in advance,
$3,200. The amount was recorded in the Prepaid Rent account.
 By July 31, half of the prepaid rent has expired and should be treated
as an expense
Adjustment July 31: Prepaid rent of $1,600 has expired for July. Adjust
account by allocating the amount to the Rent Expense account.
Prepaid Rent
July 3
3,200
Bal.
1,600
July 31 1,600
The account now reflects the
prepaid August amount
July 31 Rent Expense
Prepaid Rent
Copyright © Cengage Learning. All rights reserved.
Rent Expense
July 31
1,600
The account now reflects the
July rent expense amount
Dr.
1,600
Cr.
1,600
3–28
Depreciation of Plant and
Equipment
• When a long-term asset is purchased, the
company pays 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 © Cengage Learning. All rights reserved.
3-29
3–29
Depreciation Expense
• Is incurred during an accounting period to
produce revenue
• Must be estimated
– The useful life of the asset
• 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 © Cengage Learning. All rights reserved.
3-30
3–30
Plant Asset Contra Account
• A separate account, Accumulated Depreciation, is 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 © Cengage Learning. All rights reserved.
3-31
3–31
Type 2: Recognizing Unrecorded Expenses
Expenses are often incurred in a period, but
not yet recorded
As the expense accumulates, it is said to accrue
Common types of
unrecorded expenses
Interest
Taxes
Wages
Utilities
© Royalty-Free/Corbis
Copyright © Cengage Learning. All rights reserved.
3–32
Wages Adjustment Illustrated
Miller Design Studio pays its employees every two weeks. The last pay
period ended on July 26. The secretary worked July 29 – 31, but will not
be paid until the regular payday in August.
 The unrecorded wages for July 29 – 31 are an expense of July even though they
will not be paid until August.
Adjustment July 31: Accrue the unrecorded wages. The secretary earns $2,400 every two
weeks. ($2,400/ 10 working days = $240/day x 3 days = $720)
Wages Payable
July 31
Wages Expense
720
July 26 4,800
Bal.
The account now reflects the
liability applicable to July
July 31 Wages Expense
Wages Payable
Copyright © Cengage Learning. All rights reserved.
5,520
The account now reflects the
total July wages expense
Dr.
720
Cr.
720
3–33
Type 2: Estimated Income
Taxes
• Miller Design Studio is 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 $800.
– Income Taxes Expense is debited for $800 and Income
Taxes Payable is credited for $800.
Copyright © Cengage Learning. All rights reserved.
3-34
3–34
Type 3: Allocating Recorded,
Unearned Revenues
 Revenues can be received before they are earned
 When received in advance,
the company has an obligation
to deliver goods or perform
services
When goods
are delivered or
services are
performed, the
liability…
is converted
Copyright © Cengage Learning. All rights reserved.
Unearned
revenues are
liabilities
into a revenue
3–35
Type 3: 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 © Cengage Learning. All rights reserved.
3-36
3–36
Unearned Revenue Adjustment
Illustrated
On July 19, Miller Design Studio received $1,400 as an advance payment
for brochures to be prepared for a client. By the end of the month, $800
of the brochures were completed and accepted by the client. When the
payment was originally received, it was recorded as a liability.
 $800 of the advance payment has been earned in July
Adjustment July 31: Recognize $800 of the unearned revenue as earned in July.
Assets
= Liabilities +
Unearned Design Revenue
July 31 800
July 19 1,400
Bal.
600
The account now reflects a
balance that is unearned revenue
Stockholders’ Equity
Design Revenue
July 10 2,800
July 15 9,600
July 31 800
The account now reflects the total
revenue applicable to July
Dr.
July 31 Unearned Design Revenue
Design Revenue
Copyright © Cengage Learning. All rights reserved.
Cr.
800
800
3–37
Type 4: Recognizing Unrecorded,
Earned Revenues
 Revenues can be earned but not yet recorded
 As the revenue accumulates,
it is said to accrue
Common types of
unrecorded revenues
Interest
Revenues earned on operations
© Royalty-Free/Corbis
Copyright © Cengage Learning. All rights reserved.
3–38
Unrecorded Revenue Adjustment
Illustrated
In July, Miller Design Studio agreed to design a website for Marsh Tire
Company with the first section operational by July 31. The fee for this
section is $400.
 The fee has been earned by the end of the month, but has not been recorded
Adjustment July 31: Recognize $400 as revenue earned in July
Accounts Receivable
July 15 9,600
July 31 400
Bal.
5,000
Design Revenues
July 22 5,000
The account now reflects all
receivables for July
July 31 Accounts Receivable
Design Revenue
Copyright © Cengage Learning. All rights reserved.
July 10 2,800
July 16 9,600
July 31 800
July 31 400
The account now reflects the total
revenue applicable to July
400
400
3–39
Using the Adjusted Trial Balance to Prepare
Financial Statements
© Royalty Free PhotoDisc Collection/ Getty Images
Copyright © Cengage Learning. All rights reserved.
3–40
Adjusted Trial Balance
Record &
post adjusting
entries
 Some accounts will
Prepare
have the same
adjusted
balance they had on
trial balance
the trial balance
 Others will be
different because
adjusting entries
changed the
balances
Copyright © Cengage Learning. All rights reserved.
3–41
Preparing the Financial Statements
1. Use revenue and expense accounts from the adjusted trial
balance to prepare the income statement.
2. The statement of retained earnings is prepared using
net income or loss from the income statement and
dividends from the adjusted trial balance.
3. The resulting balance of retained earnings is used to prepare
the balance sheet along with the asset, liability, and any other
stockholders’ equity accounts from the adjusted trial balance.
Copyright © Cengage Learning. All rights reserved.
3–42
Sequence for Preparing
Financial Statements
–
Adjusted Trial Balance
Asset accounts
Liability accounts
Common Stock
Retained Earnings
Dividends
Revenue accounts
Expense accounts
Income Statement
Revenue accounts
Expense accounts
Net income
Statement of Retained Earnings
Beginning retained earnings
+ Net Income
– Dividends
Ending retained earnings
Balance Sheet
Assets
Asset accounts
Liabilities
Liability accounts
Stockholders’ Equity
Common stock
Retained earnings
Copyright © Cengage Learning. All rights reserved.
3–43
The Accounting Cycle
© Royalty Free PhotoDisc Collection/ Getty Images
Copyright © Cengage Learning. All rights reserved.
3–44
Copyright © Cengage Learning. All rights reserved.
3–45
The Closing Process:
Which Accounts Are Closed?
Permanent
accounts, or real
accounts, carry
their end-ofperiod balances
to next period
Temporary
accounts, or
nominal,
accounts begin
each period with
a zero balance
Balance sheet
accounts
Are not closed at
the end of each
period
Revenue and
Are closed at the
expense accounts end of each
and the Dividends period
account
Copyright © Cengage Learning. All rights reserved.
3–46
Closing Entries
 Set the stage for the next
period by clearing revenue
and expense accounts and
the Dividends accounts of
their balances
 Required at the end of any
period for which financial
statements are prepared
 Summarize a period’s
revenues and expenses by
transferring their balances
to the Income Summary
account
Income Summary Account
 Does not appear on financial statements
 Only used in the closing process
 Balance of account equals the net income or net
loss reported on the income statement
Copyright © Cengage Learning. All rights reserved.
3–47
The Closing Process
Expense Accounts
Revenue Accounts
xxx
xxx
Step 2: Close
expense accounts
Income Summary
xxx
Step 1: Close
revenue accounts
xxx
xx
Step 3: Close
Income Summary
Dividends
xx
Retained Earnings
Step 4:
Close
Dividends
account
Copyright © Cengage Learning. All rights reserved.
xx
xx
3–48
Still in Balance?
Now that the closing
entries have been
posted, are you sure
that the ledger
accounts are still in
balance?
Prepare a
Post-Closing
Trial Balance
© PhotoDisc Collection/ Getty Images
Copyright © Cengage Learning. All rights reserved.
3–49
Copyright © Cengage Learning. All rights reserved.
3–50