Net Income
• Net income is an increase in owner’s equity resulting from the
profitable operation of the business
• It is calculated in the income statement
• Net income is then used in the balance sheet when calculating
the owner’s equity
• Net Income= Revenues-Expenses
OVERNIGHT AUTO SERVICE
Income Statement
For the Month Ended December 31,2001
Revenue:
Repair Service Revenue
$10,380
Expenses:
Advertising Expense
$830
Wages Expense
4900
Supplies Expense
400
Depreciation Expense: Building
150
Depreciation Expense: Tools and Building
200
Net Income
6480
$3,900
Mystery Mountain Lodge
Balance Sheet
December 31, 2001
Assets
Cash
Accounts Receivable
Land
Buildings
Furnishings
Equipment
Snowmobiles
21,400
10,600
425,000
450,000
58,700
29,200
15,400
Total
1010300
Liabilities& Owners Equity
Accounts payable
54,800
Salaries payable
33,500
Interest payable
12,000
Notes payable
620,000
Total Liabilities
720,300
Stanley Gardner,
Capital
236,100
Retained earnings 3,900
Capital Stock
50,000
Total
1010300
• Income shows the results of business operations over a period of time (e.g. a
month, a year)
• The period of time covered by an income statement is termed the company’s
accounting period
• The 12 month accounting period used by an entity is called its fiscal year
• Revenue should be recognized at the time goods are sold or services are
rendered. This concept is known as the realization principle
• In measuring net income for a period, revenue should be offset by all the
expense incurred in producing that revenue. This concept is known as the
matching principle
• The recording of revenue in the period in which it is earned and recording
expenses in the period in which they are incurred is the concept of accrual
basis of accounting
• Expenditures benefiting more than one time period must be allocated over
time
Debit and Credit Rules for Revenue and
Expenses
• Revenue increases
owner’s equity, therefore,
revenue is recorded by a
credit( right side of the T
account)
• Expenses decrease
owner’s equity, therefore,
expenses are recorded by
a debit( left side of the T
account)
Adjusting Entries
• Often a transaction affects the revenue or expense of two or more
different periods. In these cases, adjusting entries are needed to
assign to each period the appropriate amounts of revenue and
expenses. These entries “adjust” the balances of various ledger
accounts-hence the name, adjusting entries.
• Adjusting entries are performed at the end of each accounting
period but prior to preparing the financial statements
Adjusting Entry
• Example: $9720 worth of supplies was purchased in
December. At the time this was recorded as Supplies
(asset). On Dec 31 the amount of supplies used must be
recorded as an expense. Supplies worth $8670 remain
with the company.
Adjustment:
Dec 31 Supplies Expense 1050
Supplies
1050
To record supplies used
Depreciation
• Definition: The systematic allocation of the cost of an
asset to expense during the periods of its useful life
• Factors relevant in determining depreciation:
▫ Cost: consists of all the necessary and reasonable
expenditures to acquire it and to prepare it for
intended use
▫ Salvage value: is an estimate of the assets value at the
end of its benefit period
▫ Useful life: the length of time it is productively used in
a company’s operations
Depreciation-
Straight Line Method
• Is the most commonly used method.
• An equal portion of the assets cost is allocated to
depreciation expense in every period of the assets
estimated useful life.
Depreciation Expense (per period)=Cost of the asset
Estimated useful life
=$10000-$1000
5 years
= $1800 per year
…Cont
Dec 31 Depreciation expense 1800
Accumulated depreciation
To record annual depreciation
1800
• The 1800 depreciation expense is reported on the income
statement among operating expenses. The1800 accumulated
depreciation is a contra asset account to the Machinery account
in the balance sheet.
Adjusting Recorded (Prepaid) Costs
Example: $2400 is the cost of 24 months of insurance.
This
is prepaid in advance. The benefits begin on Dec 1,
therefore on Dec 31 we will record the expense for one
month.
Adjustment:
Dec 31 Insurance Expense
100
Prepaid Insurance
100
To record the first month’s expired insurance
Adjusting Unearned Revenue
Example: The consulting revenue for the next 2 months amounts
to $3000. The payment is made in advance. On Dec 31, 5 days
of revenue has been earned by providing the Service.
Dec 26 Cash
3,000
Unearned Consulting Revenue 3,000
Received advance payment for the next 60 days
Adjustment:
Dec 31 Unearned Consulting Revenue250
Consulting Revenue
250
To record earned revenue that was received in
advance($3000*5/60)
Adjusting Unrecorded (Accrued) Expenses
• Accrued expenses refer to costs that are incurred in a period but
are both unpaid and unrecorded
Example: The salary is paid every Monday, however there
are three days left in the year which will be unrecorded.
Therefore, an adjusting entry must be made.
Adjustment:
Dec 31 Salaries expense
210
Salaries payable
210
To record three days accrued salary(3*$70)
Adjusting Unrecorded (Accrued) Revenues
• Accrued revenues refer to revenues earned in a period that are
both unrecorded and not yet received in cash (or other assets).
Accrued revenues commonly arise from services, products,
interest, and rent.
Example: The 30 day service fee is $2700. At Dec 31, 20 days of
services have been provided. Since the service has not been
completed, the company has neither billed the club yet nor
recorded the services already provided.
Adjustment
Dec 31 Accounts Receivable 1,800
Consulting Revenue 1,800
To record 20 days accrued revenue(2700*20/30)
Adjusting Entries and Accounting
Principles
Adjusting entries are tools by which accountants apply the realization
and matching principles
Realization principle:
• Revenues are recognized when they are earned
• Expenses are recognized as the related goods and services are used
Matching principle:
• Direct association of costs with specific revenue transactions
• Systematic allocation of costs over the useful life of the expenditure
Concept of Materiality:
• The concept of materiality allows accountants to use estimated
amounts and even to ignore other accounting principles if these
actions will not have a material effect on the financial statements.
Types of Transactions requiring
Adjustments
Before Adjusting
Category
Balance Sheet
Income Statement
Adjusting Entry
Prepaid expense
Asset overstated
Expense understated
Dr. Expense
Cr. Asset
Unearned revenues
Liability overstated
Revenue understated
Dr. Liability
Cr. Revenue
Accrued expenses
Liability understated
Expense understated
Dr. Expense
Cr. Liability
Accrued revenues
Asset understated
Revenue understated
Dr. Asset
Cr. Revenue
Accounting Cycle
1.
2.
3.
4.
5.
6.
7.
8.
Journalize transactions
Post to ledger accounts
Prepare a trial balance
Make end of period adjustments
Prepare an adjusted trial balance
Prepare financial statements
Journalize and post closing entries
Prepare an after closing trial balance
Closing the Temporary Equity Accounts
• At the end of the period journal entries are made to close the
temporary accounts( revenue, expense, and owners drawing
accounts) and they are transferred to the owner’s capital account.
• These accounts are called temporary accounts because they
accumulate the transactions of only one accounting period.
• The transfer of these accounts to the capital account has two
purposes:
▫ It updates the balance of the owner’s capital account
▫ It returns the balance of the temporary accounts to zero for the next
accounting period
Closing Entry for Revenue Accounts
• The revenue and expense accounts are closed at the end
of each period by transferring their balances to a
summary account called Income Summary
Dec 31 Repair Service Revenue 10,380
Income Summary
10,380
To close the Repair Service Revenue account
Closing Entries for Expense Accounts
Dec 31 Income Summary
6,480
Advertising Expense
830
Wages Expense
4,900
Supplies Expense
400
Depreciation Expense: Building
150
Depreciation Expense: Tools
and Equipment
200
To close the expense accounts
Closing the Income Summary Account and
Owner’s Drawing Account
Dec 31 Income Summary
Michael McBryan, Capital
To close the income summary account
for December by transferring the net
income to the owner’s capital account
3,900
Dec 31 Michael McBryan, Capital
Michael McBryan, Drawing
To close the owner’s drawing account
3,100
3,900
3,100