TOPIC 3: MEASURING BUSINESS INCOME AND COMPLETING THE ACCOUNTING CYCLE

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TOPIC 3 MEASURING BUSINESS INCOME AND COMPLETING
THE ACCOUNTING CYCLE
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Measuring Business Income

• NET INCOME IS THE NCREASE IN OE THAT RESULTS FOM
  THE OPERATIONS OF A COMPANY AND IS ACCUMULATED IN
  THE OWNERS CAPITAL ACCOUNT.
• NET INCOME REVENUES EXPENSES
• IF REVENUES lt EXPENSES THEN NET LOSS OCCURS.
• REVENUES ARE INCREASES IN OE RESULTING FROM
  SELLING GOODS, RENDERING SERVICES, OR PERFORMING
  OTHER BUSINESS ACTIVITIES.
• REVENUE PRICE OF GOODS SOLD / SERVICES GIVEN

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EXPENSES ARE DECRESAE IN OE RESULTING FROM THE
COST OF SELLING GOODS, RENDERING SERVICES, OR
PERFORMING OTHER BUSINESS ACTIVITIES. EXPENSE
COST OF GOODS / SERVICES USED UP IN EARNING
REVENUES NOTE WITHDRAWALS DECREASE OE, BUT ARE
NOT EXPENSES.
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GAAP Relationships in Revenue and Expense
Recognition
Time Period Assumption
Economic life of business can be divided into
artificial time periods
Revenue recognized in the accounting period
in which it is earned.
Revenue Recognition Principle
Expenses matched with revenues in the period
when efforts are expended to generate revenues.
Matching Principle
In accordance with GAAP
Revenue and Expenses Recognition
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Example

• A DRY CLEANING BUSINESS
• SERVED TO CUSTOMER ON JUNE 30 BUT CUSTOMER WILL
  PAY IT ON JULY 8. a ACCOUNT RECEIVABLE IS WRIITEN
  ON THE BALANCE SHEET AT JUNE 30.
• YOUR WORKER PAID AN EFFORT TO CLEAN THAT CLOTHING
  BUT YOU DID NOT PAY SALARIES ON JUNE 30. BUT
  WRITE a ACCOUNT PAYABLE ON THE B/S AT JUNE 30.

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The Basics of Adjusting Entries
ADJUSTED ENTRIES ARE NEEDED TO ENSURE THAT THE
REVENUE RECOGNITION AND MATCING PRINCIPLE ARE
FOLLOWED. TPYES OF ADJUSTING ENTRIES

• ACCRUALS
• ACCRUED REVENUES
• ACCRUED EXPENSES

• PREPAYMENTS
• PREPAID EXPENSE
• UNEARNED REVENUES

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PREPAID EXPENSE EXPENSE PAID IN CASH AND
RECORDED AS ASSETS BEFOE THEY ARE USED OR
CONSUMED. EX. PREPAID INSURANCE, PREPAID RENT,
SUPPLIES, DEPRECIATION Example 1. Prepaid
Insurance On January 1, Drake Company paid 3,000
for a one-year insurance policy. At the end of
January, 250 has expired. The journal entry
is Jan. 1 Prepaid Insurance
3,000 Cash
3,000 Jan. 31
Insurance Expense 250
Prepaid Insurance
250

• Insurance Expense is 250 on the I/S for January.
• Prepaid Insurance is 2,750 on the B/S for Jan.
  31.

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Example 2. Office Supplies On January 1, office
supplies of 700 were acquired on credit. On Jan.
31, a count of office supplies reveals that 600
are on hand. Hence 100 of supplies were used
during the month. Jan. 1 Office Supplies
700 Accounts
Payable 700 Jan. 31
Office Supply Expense 100
Office Supplies
100
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Example 3. Depreciation Depreciation on the
office equipment is estimated to be 480 a year.
(480/12 40 / month) depre. For October is
adjusted by the following entry Oct. 1
Office Equipment 5,000
Cash
5,000 Oct. 31 Depreciation Expense
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Accumulated Depreciation
-Office Equipment
40
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UNEARNED REVENUE CASH RECEIVED AND RECORDED AS
LIABILITIES BEFORE REVNUE IS EARNED. EX. RENT,
MAGAZINE SUBSCRIPTION,ETC Example 1. Unearned
Professional Fees On Jan.1, a client made an
advance payment of 1,000 for professional fees
to be rendered over the next four months. The
first month's service is 250. Jan. 1 Cash
1,000
Unearned Professional Fee
1,000 31 Unearned Professional
250 Fee Income
Professional Fee Income 250
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Example 2. Uneraned Rental Income On Jan. 1 , a
landlord receives 500 from a tenant as an
advance fro the months rent. The journal entries
are Jan. 1 Cash
500 Unearned
Rental Income 500 31
Unearned Rental Income 500
Rental Income
500
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ACCRUED REVENUES REVENUES EARNED BUT NOT YET
RECEIVED IN CASH OR RECORDED. Example Rent
Receivable A landlord has not received Jan. rent
of 300 from a tenant. The adjusting entry at the
end of Jan. is Jan. 31 Rent Receivable
300 Rental Income
300
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ACCRUED EXPENSES EXPENSES INCURRED BUT NOT YET
PAID IN CASH OR RECORDED. Example Accrued
salaries Payable The last payroll date was Jan.
28. the next payroll date is Feb.. 11. for the
last few days of the month the company owes its
employees 500 in salaries. The appropriate
journal entry for accrued salaries is
Jan. 31 Salary Expense 500
Salary Payable
500
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Adjusted Trial Balance

• AFTER ALL ADJUSTING ENTRIES HAVE BEEN
  JOURNALIZED AND POSTED, ANOTHER TRIAL BALANCE IS
  PREPARED FROM THE LEDGER ACCOUNTS. THIS TRIAL
  BALANCE IS CALLED AN ADJUSTED TRIAL BALANCE.

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Preparing Financial Statements

• FINANCIAL STATEMENTS CAN BE PREPARED DIRECTLY
  FROM AN ADJUSTED TRIAL BALANCE.
• THE I/S IS PREPARED FROM THE REVENUE EXPENSE
  ACCOUNTS IN THE ADJUSTED TRIAL BALANCE.
• THE B/S IS PREPARED FROM ASSETSLIABILITY FROM
  THE STATEMENT OF OE.

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Accrual versus Cash Basis of Accounting

• ACCRUAL BASIS ACCOUNTING MEANS THAT TRANSACTION
  THAT CHANGE A COMPANYS FINANCIAL STATEMENTS ARE
  RECORDED IN THE PERIODS IN WHICH THE EVENTS
  OCCUR, RATHER THAN IN THE PERIODS IN WHICH THE
  COMPANY RECEIVES OR PAYS CASH.
• UNDER CASH BASIS ACCOUNTING, REVENUE IS RECORDED
  ONLY WHEN THE CASH IS RECEIVED, AND AN EXPENSE IS
  RECORDED ONLY WHEN CASH IS PAID. THE CASH BASIS
  OF ACCOUNTING IS NOT IN ACCORDANCE WITH GAAP
  BECAUSE OF VIOLATING THE REVENUE RECOGNITION
  PRINCIPLE AND MATCHING PRINCIPLE.

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Completing the Accounting Cycle

• AT THE END OF THE ACCOUNTING PERIOD, THE BOOKS
  ARE CLOSED. AFTER THE FINANCIAL STATEMENTS ARE
  PREPARED AT THE END OF THE FISCAL YEAR, INCOME
  SUMMARY ACCOUNT IS ESTABLISHED.
• CLOSING ENTRIES
• CLEAR BLANCES OF REVENUE EXPENSES ACCTS
  WITHRAWALS SO THAT THEY HAVE ZERO BALANCES AT THE
  BEG. OF THE NEXT ACCTG PERIOD
• SUMMARIZE A PERIODS REVENUE EXPENSES IN THE
  INCOME SUMMARY ACCOUNT SO THAT NET INCOME / LOSS
  FOR THE PERIOD CAN BE TRANSFERRED AS TOTAL TO
  OWNERS CAPITAL.

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QUIZ TIME FOR TOPIC 3.