Chapter 3
Measuring Business
Income
Skyline College
Why Must a Business Be Profitable?
To succeed
To survive
To increase
stockholders’ equity
To demonstrate
positive performance
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Accountants use the term net income when
referring to profitability
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3–2
Net Income
Net Income = Revenues – Expenses
Net increase in stockholders’ equity
resulting from operations
Retained Earnings
_
+
Net income is
accumulated
here
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If expenses exceed revenues, a net loss occurs
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Revenues
Increases in stockholders’
equity resulting from…
 selling goods
 rendering services
 performing other business
activities
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Cash Received
Promise to Pay Received
(Accounts Receivable)
Not all increases in stockholders’ equity arise from revenues
(Example: Issue stock)
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Expenses
Decreases in stockholders’ equity resulting
from the cost of…
 selling goods
 rendering services
 performing other business
activities
Cost of doing
business
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Squared Studios/
 Salaries Expense
Getty Images
 Rent Expense
 Utilities Expense
 Depreciation of a building
Not all decreases in stockholders’ equity arise from expenses
(Example: Dividends, net losses)
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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?
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3–6
Continuity
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…
Income
Statement
$
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when it will
become an
expense.
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Periodicity
 Assigns revenue and expenses to a
specific time period
 Time periods are of equal length
 The 12-month accounting period is
called a fiscal year (does not have to
correspond with the calendar year)
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 Monthly or quarterly periods are
called interim periods
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3–8
What Is Accrual Accounting?
Revenues and expenses are recorded in the
periods in which they occur regardless when
cash is received or paid
Accrual accounting is accomplished by:
Recording revenues when earned
Recording expenses when incurred
Adjusting the accounts
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3–9
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
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3–10
Revenue Recognition Illustrated
Treadle Website Design, Inc. designs a website for a
customer under a predetermined agreement and bills
for the service. The customer understands the price
and there is a reasonable expectation that the
customer will pay the bill.
Should Treadle recognize the revenue when it bills
the customer?
Because all four conditions have been met, Treadle
should recognize the revenue by debiting Accounts
Receivable and crediting Design Revenue.
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3–11
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
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3–12
Expense Recognition Illustrated
Treadle Website Design, Inc. receives
its utility bill for the period.
Should Treadle recognize the
expense when it receives the bill?
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Treadle has obviously entered into an agreement to
pay for utility services as used. Because the expense
has been incurred and has helped produce revenue,
it should be recorded by debiting Utilities Expense
and crediting Accounts Payable.
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3–13
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.
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 Manipulation of revenues
and expenses to achieve
a specific outcome –
earnings management
 Not illegal, but not the
best practice
Fraudulent
financial
reporting
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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
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Impact of Adjustments
 Do not affect cash flows because they never involve
the Cash account
 Affect one balance sheet account and one income
statement account
 Necessary to measure
profitability
 Affect profitability
comparisons from
one period to the
next
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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
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3–17
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
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Two common kinds of adjustments
Prepaid Expenses
Depreciation of Plant and Equipment
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3–18
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
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3–19
Prepaid Rent Adjustment Illustrated
On July 3, Treadle Website Design 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
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Rent Expense
July 31
1,600
The account now reflects the
July rent expense amount
Dr.
1,600
Cr.
1,600
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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
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3–21
Wages Adjustment Illustrated
Treadle Website Design 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
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5,520
The account now reflects the
total July wages expense
Dr.
720
Cr.
720
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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
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Unearned
revenues are
liabilities
into a revenue
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Unearned Revenue Adjustment
Illustrated
On July 19, Treadle Website Design 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 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
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Cr.
800
800
3–24
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
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3–25
Unrecorded Revenue Adjustment
Illustrated
In July, Treadle Website Design 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
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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
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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
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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.
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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.
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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
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Overview of the
Accounting Cycle
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3–30
The Closing Process:
Which Accounts Are Closed?
Permanent
accounts
carry their endof-period
balances to next
period
Temporary
accounts
accounts begin
each period with
a zero balance
Balance sheet
accounts
Revenue and
expense accounts
and the Dividends
account
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Are closed at the
end of each
period so the
accounts can start
counting the next
period’s activity
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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
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 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
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The Closing Process
Expense Accounts
Revenue Accounts
_
xxx
_
+
Balance
xxx
Step 2: Close
expense accounts
Income Summary
_
xxx
+
+
Balance
Step 1: Close
revenue accounts
xxx
Balance
Step 3: Close
Income Summary
Dividends
xx
+
_
xx
Retained Earnings
_
Step 4:
xx
Balance
Close
Dividends
account
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+
xx
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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
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