Finanacial Accounting Ch3

8/3/2019 Finanacial Accounting Ch3

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Copyright2001 by HoughtonMifflin Company. All rights reserved.

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Financial AccountingFinancial Accounting

Belverd E. Needles, Jr.Belverd E. Needles, Jr.

Marian PowersMarian Powers

- - - - - - - - - - -

Multimedia Slides by:

Dr. Howard A. Kanter, CPA

DePaul University

Milton M. Pressley

University of New Orleans


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Chapter 3Chapter 3

Measuring Business IncomeMeasuring Business Income

Belverd E. Needles, Jr.Belverd E. Needles, Jr.

Marian PowersMarian Powers

- - - - - - - - - - -

Multimedia Slides by:

Dr. Howard A. Kanter, CPA

DePaul University

Milton M. Pressley

University of New Orleans


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3

LEARNING OBJECTIVESLEARNING 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 accountingand explaintwo broad ways of accomplishing it.


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4.State four principal situations that

require adjusting entries.

5.Prepare typical adjusting entries.

6.Prepare financial statements froman adjusted trial balance.

LEARNING OBJECTIVESLEARNING OBJECTIVES(continued)(continued)


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5

Analyze cash flows from accrual-based information.

Supplemental ObjectivesSupplemental Objectives


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6

Profitability Measurement:Profitability Measurement:

The Role of Business IncomeThe Role of Business Income

Objective1

Objective1

Define net income and its two

major components, revenues

and expenses.


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Profitability Measurement: TheProfitability Measurement: The

Role of Business IncomeRole of Business Income

Profitability and liquidity are the two

major goals of a business.

To survive, a business must earn aprofit.

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.


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Net IncomeNet Income

Net income is the net increase in

stockholders equity that results from

the operations of a company.

Net income is accumulated in theRetained Earnings account.

Net Income = Revenues - Expenses.

R > E, net profit. R < E, net loss.


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RevenuesRevenues

Revenues are increases in SE resulting

from selling goods or providing services.

Revenue for a given period equals:

Cash + Receivables from goods andservices provided.

Liabilities are generally not affected by

revenues.

Stockholders investments increase SE but

are not revenues.


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ExpensesExpenses

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.


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The Accounting Period IssueThe Accounting Period Issue

Objective 2aObjective 2a

Explain the difficulties of

income measurement caused

by the accounting period

issue.


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The Accounting Period IssueThe 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 aboutperiodicity.

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.


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Copyright2001 by HoughtonMifflin Company. All rights reserved. 13

The Measurement ofThe Measurement of

Business IncomeBusiness 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. Thefiscal yearis 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 ofthe business dictate.


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The Continuity IssueThe Continuity Issue

Objective 2bObjective 2b

Explain the difficulties ofincome measurement caused by

the continuity issue.


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The Continuity IssueThe Continuity Issue

The measurement of business income requiresthat certain expenses and revenues be allocated

over several accounting periods.

The continuity issue relates to the estimated

number of accounting periods in the businessentitys life.

The accountant assumes that an entity is agoing

concern, that the entity will continue indefinitely.

If a firm is not a going concern, financialstatements may be prepared on the basis of the

liquidation value of the assets -- that is, what

they will bring in cash.


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The Matching IssueThe Matching Issue

Objective 2cObjective 2c

Explain the difficulties ofincome measurement

caused by the matching

issue.


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The Matching IssueThe Matching Issue

The cash basis of accounting recognizes revenues whenreceived 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 appropriateaccounting 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.


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Accrual AccountingAccrual Accounting

Objective 3Objective 3

Define accrual accountingandexplain two broad ways of

accomplishing it.


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Accrual accounting attempts to record the

financial effects on an enterprise of

transactions and other events and

circumstances . . . in the periods in whichthose 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.


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Implementation ofImplementation of


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, anexpense is recorded before the cash is paid in

the Accounts Payable account.


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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.

2. By adjusting the accounts.


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The Adjustment ProcessThe Adjustment Process


State four principal situations thatrequire adjusting entries.


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The Adjustment ProcessThe 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.


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FourTypes of Adjusting EntriesFourTypes 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.


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Copyright2001 by Houghton

Mifflin Company. All rights reserved.

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DeferralsDeferrals

The recognition of an expense

already paid (Type 1 adjustment),or

A revenue received in advance

(Type 3 adjustment).

A deferralis the postponement of:


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AccrualsAccruals

An accrualis the recognition of a

revenue (Type 4 adjustment) or

expense (Type 2 adjustment) that hasarisen but has not yet been recorded.


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Allocating Recorded Costs BetweenAllocating Recorded Costs Between

Two or More Accounting PeriodsTwo or More Accounting Periods


Prepare typical adjusting entries.


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Type 1:Type 1: AllocatingAllocating Deferred ExpensesDeferred ExpensesPrepaid Expenses: Rent ExpensePrepaid Expenses: Rent Expense

Dr. Cr.

Jan. 31 Rent Expense 400

Prepaid Rent 400

Rent Expense

Jan. 31 400Jan. 31 400

Prepaid RentTransaction

Analysis

Rules

Entry

Jan. 2 800 Jan. 31 400Jan. 31 400


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Type 1: Allocating Deferred ExpensesType 1: Allocating Deferred Expenses

Prepaid Expenses: Insurance ExpensePrepaid Expenses: Insurance Expense

Dr. Cr.Jan. 31 Insurance Expense 40

Prepaid Insurance 40

Insurance Expense

Jan. 31 40Jan. 31 40

Prepaid InsuranceTransaction

Analysis

Rules

Entry

Jan. 8 480 Jan. 31 40Jan. 31 40


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Type 1:Type 1: Allocating Deferred ExpensesAllocating Deferred ExpensesPrepaid Expenses: Art Supplies ExpensePrepaid Expenses: Art Supplies Expense

Dr. Cr.

Jan. 31 Art Supplies Expense 500

Art Supplies 500

Art Supplies

Jan. 31 500Jan. 31 500

Art Supplies Expense

Transaction

Analysis

Rules

Entry

Jan. 6 1,800

Jan. 31 500Jan. 31 500


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Type 1:Type 1: AllocatingAllocating Deferred ExpensesDeferred ExpensesPrepaid Expenses: Office SuppliesPrepaid Expenses: Office Supplies

Dr. Cr.Jan. 31 Office Supplies Expense 200

Office Supplies 200

Office Supplies

Jan. 31 200Jan. 31 200

Office Supplies Expense

Transaction

Analysis

Rules

Entry

Jan. 6 800 Jan. 31 200Jan. 31 200


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Adjustment for Prepaid (Deferred) ExpensesAdjustment for Prepaid (Deferred) Expenses


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Type 1:Type 1: Allocating Deferred ExpensesAllocating Deferred ExpensesDepreciation ofPP&E: Art EquipmentDepreciation ofPP&E: Art Equipment

Dr. Cr.

Jan. 31 Depreciation Expense, Art Equipment 70

Accumulated Depreciation, Art Equipment 70

Accumulated Deprn, Art Equipment

Jan. 31 70Jan. 31 70

Depreciation Expense, Art Equipment

Transaction

Analysis

Rules

EntryJan. 31 70Jan. 31 70


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Type 1:Type 1: Allocating Deferred ExpensesAllocating Deferred ExpensesDepreciation ofPP&E: Office EquipmentDepreciation ofPP&E: Office Equipment

Dr. Cr.

Jan. 31 Depreciation Expense, Office Equipment 50

Accumulated Depreciation, Office Equipment 50

Accumulated Deprn, Office Equipment

Jan. 31 50Jan. 31 50

Depreciation Expense, Office Equipment

Transaction

Analysis

Rules



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Adjustment for DepreciationAdjustment for Depreciation


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Type 2:Type 2: Recognizing Unrecorded (Accrued)Recognizing Unrecorded (Accrued)ExpensesExpenses

Accrued Expenses: Accrued WagesAccrued Expenses: Accrued WagesDr. Cr.

Jan. 31 Wages Expense 180

Wages Payable 180

Wages Payable

Jan. 31 180Jan. 31 180

Wages Expense

Transaction

Analysis

Rules

Entry

Jan. 12 600

26 600

31 18031 180

T 2T 2


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Type 2:Type 2: Recognizing Unrecorded (Accrued)Recognizing Unrecorded (Accrued)ExpensesExpenses

Accrued Expenses: Estimated Income TaxesAccrued Expenses: Estimated Income Taxes

Dr. Cr.

Jan. 31 Income Taxes Expense 400

Income Taxes Payable 400

Income Taxes Payable

Jan. 31 400Jan. 31 400

Income Taxes Expense

Transaction

Analysis

Rules



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Adjustment for Unrecorded (Accrued) ExpensesAdjustment for Unrecorded (Accrued) Expenses


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Type 3:Type 3: Allocating Deferred RevenuesAllocating Deferred RevenuesDeferred Revenues: Unearned FeesDeferred Revenues: Unearned Fees

Dr. Cr.

Jan. 31 Unearned Art Fees 400

Art Fees Earned 400

Unearned Art Fees

Jan. 15 1,000

Art Fees Earned

Transaction

Analysis

Rules

Entry

Jan. 31 400Jan. 31 400

Jan. 31 400Jan. 31 400


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Adjustment for Unearned (Deferred) RevenuesAdjustment for Unearned (Deferred) Revenues

T 4T 4


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Type 4:Type 4: Recognizing Unrecorded (Accrued)Recognizing Unrecorded (Accrued)RevenuesRevenues

Accrued Revenues: Advertising FeesAccrued Revenues: Advertising Fees

Dr. Cr.

Jan. 31 Fees Receivable 200

Advertising Fees Earned 200

Fees Receivable

Jan. 31 200Jan. 31 200

Advertising Fees Earned

Transaction

Analysis

Rules

Entry

Jan. 10 1,400

19 2,800

31 20031 200


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Adjustment for Unrecorded (Accrued) RevenuesAdjustment for Unrecorded (Accrued) Revenues


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Using the Adjusted Trial Balance toUsing the Adjusted Trial Balance to

Prepare Financial StatementsPrepare Financial Statements

Objective 6Objective 6Prepare financial statements

from an adjusted trial

balance.


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The Adjusted Trial Balance (ATB)The Adjusted Trial Balance (ATB)

The ATB is prepared after adjustingentries 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 AT

B by copying the appropriateaccounts to the appropriate financial

statement.


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Cash Flows, Accrual Accounting,Cash Flows, Accrual Accounting,

and Management Objectivesand Management Objectives

Supplemental Objective 7Supplemental Objective 7

Analyze cash flows from

accrual-based information.


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Cash Flows from AccrualCash Flows from Accrual--BasedBased

InformationInformation

1. Management has a liquidity

goal, which is measured by cash

flow.


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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 todetermine cash flow.


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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 receiptsfrom revenues.


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Accrued ExpenseBeginning balance + Expense for the period

- Ending balance = Cash payments for

expenses.Accrued Revenue

Beginning balance + Revenue for period

- Ending balance = Cash receipts fromrevenues.


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1. Define net income and its two majorcomponents, 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 accountingandexplain two broad ways of

accomplishing it.

OKAY, LETS REVIEW...OKAY, LETS REVIEW...


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Mifflin Company All rights reserved

51

4. State four principal situations that

require adjusting entries.

5.P

repare typical adjusting entries.6. Prepare financial statements from

an adjusted trial balance.

7. Analyze cash flows from accrual-

based information.

AND FINALLY...AND FINALLY...

Finanacial Accounting Ch3

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