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Financial AccountingFinancial Accounting
Belverd E. Needles, Jr.Belverd E. Needles, Jr.
Marian PowersMarian Powers
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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
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Multimedia Slides by:
Dr. Howard A. Kanter, CPA
DePaul University
Milton M. Pressley
University of New Orleans
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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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Analyze cash flows from accrual-based information.
Supplemental ObjectivesSupplemental Objectives
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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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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 AccountingAccrual Accounting
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 AccountingAccrual Accounting
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
Objective 4Objective 4
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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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
Objective 5Objective 5
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
EntryJan. 31 50Jan. 31 50
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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
EntryJan. 31 400Jan. 31 400
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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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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...