Chapter 3
Measuring Business Income
Copyright © Cengage Learning. All rights reserved.
Profitability Measurement: Issues
and Ethics
• Objective 1
– Define net income, and explain the assumptions
underlying income measurement and their ethical
application.
Copyright © Cengage Learning. All rights reserved.
3-2
Net Income
• Profitability is a major goal of a business.
– For a business to survive, it must earn a profit
• Accountants prefer to use the term net income—the
net increase in stockholders’ equity that results
from a company’s operations.
• Net Income = Revenues – Expenses
Copyright © Cengage Learning. All rights reserved.
3-3
Revenues
• Increases in stockholders’ equity resulting from
– Selling goods
– Rendering services
– Performing other business activities
• Not all increases in stockholders’ equity arise from revenues
– Increases resulting from stockholders’ 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 © Cengage Learning. All rights reserved.
3-4
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 © Cengage Learning. All rights reserved.
3-5
Expenses
• Decreases in stockholders’ 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 © Cengage Learning. All rights reserved.
3-6
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.
3-7
Income Measurement Assumptions
• Continuity
• Periodicity
• Matching
Copyright © Cengage Learning. All rights reserved.
3-8
Continuity
• Measuring transactions requires that certain expenses
and revenues be allocated over several accounting
periods.
• The accountant assumes the business is a going
concern (the business will continue to operate
indefinitely, unless there is evidence to the contrary).
• 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.
Copyright © Cengage Learning. All rights reserved.
3-9
Periodicity
• Addresses the difficulty of assigning revenues and
expenses to a specific period of time.
• Accountants 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.
• 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.
3-10
Matching
• Addresses 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 © Cengage Learning. All rights reserved.
3-11
Earnings Management
The manipulation of
revenues and expenses to
achieve a specific
outcome
Copyright © Cengage Learning. All rights reserved.
Why do companies
manage earnings?
Meet previously
announced goals
Keep stock price steady
Earn bonuses
Avoid embarrassment
3-12
Accrual Accounting
• Objective 2
– Define accrual accounting, and explain how it is
accomplished.
Copyright © Cengage Learning. All rights reserved.
3-13
What Is Accrual Accounting?
• Encompasses all the techniques accountants use to
apply the matching rule.
• Revenues and expenses are recorded in the periods
in which they occur rather than in the periods in
which they are received or paid.
Copyright © Cengage Learning. All rights reserved.
3-14
Accrual Accounting
Accomplished in the following ways:
1. Recording revenues when earned
2. Recording expenses when incurred
3. Adjusting the accounts
– Prepaid expenses (asset)
– Payables (liability)
Copyright © Cengage Learning. All rights reserved.
3-15
Adjustments and Ethics
• Adjustments do not affect cash flows in the current
period and never involve the Cash account.
• Adjustments are important because they affect net
income, profitability comparisons, and the balance
sheet.
• Provide information about a company’s future cash
inflows and outflow.
Copyright © Cengage Learning. All rights reserved.
3-16
The Adjustment Process
• Objective 3
– Identify four situations that require adjusting entries, and
illustrate typical adjusting entries.
Copyright © Cengage Learning. All rights reserved.
3-17
Adjusting Entries
• Used to apply accrual accounting to transactions
that span more than one accounting period
• Adjusting entries must
– Include at least one balance sheet account
– Include at least one income statement account
– Never affect the Cash account
Copyright © Cengage Learning. All rights reserved.
3-18
When to Make Adjustments
Type 1: Allocating recorded costs between two or
more accounting periods
Type 2: Recognizing unrecorded expenses
Type 3: Allocating recorded, unearned revenues
between two or more accounting periods
Type 4: Recognizing unrecorded, earned revenues
Copyright © Cengage Learning. All rights reserved.
3-19
Deferrals
• A deferral is the postponement of
– The recognition of an expense already paid in advance
• Type 1 adjustment
– The recognition of a revenue received in advance
• Type 3 adjustment
Copyright © Cengage Learning. All rights reserved.
3-20
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 © Cengage Learning. All rights reserved.
3-21
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 © Cengage Learning. All rights reserved.
3-22
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
• Stockholders’ equity will be overstated
• Net income will be overstated
Copyright © Cengage Learning. All rights reserved.
3-23
Four Types of Adjustments
INCOME STATEMENT
BALANCE SHEET
Expense
Revenue
Assets
Liabilities
1. Recorded costs are
allocated between
two or more
accounting periods
2. Expenses are
incurred but not yet
recorded
(Deferred Expenses)
(Accrued Expenses)
4. Revenues are
earned but not yet
recorded
(Accrued Revenues)
Copyright © Cengage Learning. All rights reserved.
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
Type 1: Prepaid Rent Adjustment
On July 3, Miller Design Studio paid two months’ rent in advance for
$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
1,600 July 31
The account now reflects the
prepaid August amount
Copyright © Cengage Learning. All rights reserved.
Rent Expense
July 31
1,600
The account now reflects the
July rent expense amount
3-25
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.
3-26
Depreciation 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 © Cengage Learning. All rights reserved.
3-27
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.
3-28
Type 2 Adjustment:
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, the are said
to accrue
• Common unrecorded (accrued) expenses or
payables
– Interest
– Taxes
– Wages
Copyright © Cengage Learning. All rights reserved.
3-29
Type 2: Wages
Adjustment Illustrated
Miller Design Studio pays its employees every two weeks. The last pay
period ended on July 26. The assistant worked July 29 – 31, but will not
be paid until the regular payday in August.
 The wages for July 29 – 31 are an expense of July even though they will
not be paid until August.
Adjustment July 31: Accrue the wages expense and payable. The
assistant earns $2,400 every two weeks. ($240/day x 3 days = $720)
Wages Payable
720 July 31
The account now reflects the
wages applicable to July
July 31 Wages Expense
Wages Payable
Copyright © Cengage Learning. All rights reserved.
Wages Expense
July 26 4,800
July 31 720
Bal.
5,520
The account now reflects the
total July wages expense
720
720
3-30
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.
3-31
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.
3-32
Type 3: Unearned Revenue
Adjustment
On July 19, Miller Design Studio received $1,400 as an advance payment
for designs to be prepared for a client. By the end of the month, $800 of
the design was completed and accepted by the client. When the payment
was 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.
Unearned Design Revenues
Design Revenues
1,400 July 19
July 31 800
800 July 31
600 Bal.
The account now reflects a
balance that is unearned revenue
The account now reflects the revenue
applicable to July for this contract
July 31 Unearned Design Revenues
Design Revenues
Copyright © Cengage Learning. All rights reserved.
800
800
3-33
Type 4: 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 © Cengage Learning. All rights reserved.
3-34
Type 4: Unrecorded Revenue
Adjustment
In July, Miller Design Studio agreed to create two advertisements for
Maggio’s Pizza Company, with the first ad completed by July 31. The
fee for this first completion 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
5,000 July 22
The account now reflects all
receivables for July
July 31 Accounts Receivable
Design Revenue
Copyright © Cengage Learning. All rights reserved.
Design Revenue
2,800
9,600
800
400
13,600
July 10
July 15
July 31
July 31
Bal.
The account now reflects the revenue
applicable to July for this contract
400
400
3-35
Stop & Review
Q. What do plant and equipment, office supplies,
and prepaid insurance have in common?
A. They are all assets, their costs must be allocated to
expenses as they are used over time, and they
require adjusting entries at the end of the
accounting period.
Copyright © Cengage Learning. All rights reserved.
3-36
Using the Adjusted Trial Balance to
Prepare Financial Statements
• Objective 4
– Prepare financial statements from an adjusted trial
balance.
Copyright © Cengage Learning. All rights reserved.
3-37
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 © Cengage Learning. All rights reserved.
3-38
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.
3-39
Chapter Review
1. Define net income, and explain the assumptions
underlying income measurement and their ethical
application.
2. Define accrual accounting, and explain how it is
accomplished.
3. Identify four situations that require adjusting
entries, and illustrate typical adjusting entries.
4. Prepare financial statements from an adjusted trial
balance.
Copyright © Cengage Learning. All rights reserved.
3-40
Chapter Review (cont’d)
4. Prepare financial statements from an adjusted trial
balance.
Copyright © Cengage Learning. All rights reserved.
3-41