Week 2 - Accrual Accounting and the Income Statement.pdf

8/14/2019 Week 2 - Accrual Accounting and the Income Statement.pdf

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KNOWLEDGE FOR ACTION

Income Statement

• Reports increase in shareholders’ equity due to operations over aperiod of time

• Income statement equation:

– Net Income = Revenue – Expenses

– Net income is also called “earnings” or “net profit”

• All income statement items are based on Accrual Accountingprinciples




Accrual Accounting

• Accounting recognition of revenues and expenses are tied tobusiness activities, not to cash flows

• Revenues are recognized when goods or services are provided(revenue recognition criteria)

=> Revenues ≠ Cash inflows

• Expenses are recognized in the same period as the revenues theyhelped to generate (matching principle)

=> Expenses ≠ Cash outflows

=> Net income ≠ Net cash flow




Revenue

• Revenue is an increase in shareholders’ equity (not necessarilycash) from providing goods or services.

• Revenue is recognized when both:

– It is earned (i.e. goods or services are provided) and

– It is realized (i.e. payment for goods or services received in cash or somethingthat can be converted to a known amount of cash)

• These conditions are called revenue recognition criteria




Expenses

• Expenses are decreases in shareholders’ equity (not necessarilycash) that arise in the process of generating revenues

• Expenses are recognized when either :

– Related revenues are recognized (product costs) or

– Incurred, if difficult to match with revenues (period costs and unusual events)

• The underlying recognition concepts are the

– Matching principle (product vs. period costs)

– Conservatism principle (unusual events): recognize anticipated lossesimmediately, recognize anticipated gains only when realized




How Much Revenue Is Recognized in December?

1. BOC delivers $500,000 worth of washing machines in December tocustomers who don’t have to pay until February.

2. BOC collects $300,000 cash in December for washing machinesdelivered in October.

3. BOC Realty leases space to a tenant for the months of December andJanuary for $20,000, all of which is paid for in cash in December.




How Much Revenue Is Recognized in December?

4. BOC Aerospace receives an order for a $400,000 jet in December to bedelivered in July.

5. BOC Bank is owed $100,000 of interest on a loan for December andreceives the payment in January.

6. BOC issues 20,000 shares of stock in December and receives $10/share,which is $2/share more than they expected.




How Much Expense Is Recognized in December?

1. BOC Automotive buys engines worth $2,000,000 in December for cash.

2. BOC Automotive uses the engines to make cars at a total cost of$10,000,000 in December.

3. BOC Automotive sells cars costing $8,000,000 in December for$15,000,000.




How Much Expense Is Recognized in December?

4. BOC Automotive incurs $180,000 in salaries for its marketing staff inDecember.

5. BOC Automotive pays its auditor $50,000 in December for services to berendered in December and January.

6. BOC Automotive pays $1,200,000 in cash dividends in December.




Relic Spotter Inc. Case

• In the prior video, we did the first 14 transactions for this start-upcompany.

• We will resume the case with transactions related to Revenues andExpenses.

• Some of the transactions will be “ summary” entries to record six-months worth of activity.

• As we did last time, we will record journal entries and post to t-

accounts for each transaction.

• After each transaction is read, you should pause the video and try todo the journal entry. Think about (1) what accounts are involved? (2)did they increase or decrease? (3) do we debit or credit?

• Then, resume the video to see the answer and the explanation.




Relic Spotter Inc. Case: Transaction 15

• (15) In a search for new revenue opportunities, Park initiated anunlimited rental arrangement with the Penn Antiquit ies Club onDecember 1, 2012. Under this arrangement, the club paid Relic

Spotter $1,200 cash upfront for unlimited rentals over the next year.

• Journal Entry





• (16) For the six months ended December 31, 2012, rental revenues onthe Metal Detectors totaled $124,300. Most of the rentals were paid incash immediately. However, as an init iative to reward repeat

customers, Park allowed a select number of frequent renters tocharge their rentals and be billed later. As of December 31, 2012,$4,200 was outstanding under this plan.

• Journal Entry





• (17) During the period between July 1 and December 31, Parkpurchased $40,000 of sundries inventory, of which $38,000 had beenpaid in cash and $2,000 was sti ll owed at December 31.

• Journal Entry




Relic Spotter Inc. Case: Transaction 18• (18) Relic Spotter recorded sales of sundries totaling $35,000 for the

six months ended December 31, all received in cash.

• Journal Entry




Relic Spotter Inc. Case: Transaction 19• (19) The original cost of these sundries was $30,000.

• Journal Entry




Relic Spotter Inc. Case: Transaction 20• (20) Finally, Relic Spotter’s two employees were paid wages of

$32,000 total during this six-month period and Park drew a salary of$50,000.

• Journal Entry




The Accounting Cycle

Analyze

Transactions

Journalizeand Post

During Period

UnadjustedTrial Balance

End of Period

4. Unadjusted trial balance: Account balances are summed on a worksheet

to verify that debits equal credits.




Quick Review: The Accounting Cycle

Analyze

Transactions

Journalize

and Post

Adjusting

Entries

Financial

Statements

Closing

Entries

During PeriodStart new period

Unadjusted

Trial Balance

Adjusted

Trial Balance

End of Period




Adjusting Entries

• Adjusting entries

– Internal transactions that update account balances in accordance with accrual

accounting prior to the preparation of financial statements

• Deferred Revenues and Expenses

– Update existing account balances to reflect current accounting values

– Cash flow in past; record revenue/expense now

• Accrued Revenues and Expenses

– Create new account balances to reflect unrecorded assets or liabili ties

– Record revenue/expense now; cash flow in future




Deferred Expenses

• Question: Are there any assets that have been “ used up” this

period and should be expensed?

• Examples:

– Prepaid Rent

– Prepaid Insurance

– Depreciation or amortization

• Property, plant, and equipment

• Intangible assets (e.g., Patents)

• Journal Entry:

Dr. Expense

Cr. Prepaid Asset




Deferred Revenues

• Question: Are there any liabil ities that have been fulfilled by

delivery of goods or services that should be recognized as revenue?

• Examples:

– Unearned rental revenue

– Deferred subscription revenue

• Journal Entry:

Dr. Unearned Revenue Liability

Cr. Revenue




Accrued Expenses

• Question: Have any expenses accumulated during the period that

have not yet been recorded?

• Examples:

– Income Taxes Payable

– Interest Payable

– Salaries and Wages Payable

• Journal Entry:

Dr. Expense

Cr. Payable Liability




Accrued Revenue

• Question: Have any revenues accumulated during the period that

have not yet been recorded?

• Examples:

– Interest Receivable

– Rent Receivable

• Journal Entry:

Dr. Receivable Asset

Cr. Revenue




Depreciation and Amortization• Allocate the original cost of a long-lived asset over its useful life

– Matches the total expense (original cost) of asset to the revenues it generates

over its period of use

• Terminology – Tangible assets (physical assets) require depreciation

– Intangible assets (abstract assets) require amortization




Depreciation and Amortization• Accounting Procedure

– Depreciation is not deducted from the tangible asset account. Rather, it is

recorded in a Contra Asset Account (XA) called Accumulated Depreciation, which

• has a credit balance• is subtracted from PP&E on the balance sheet to get the “ Net Book Value”

– Amortization is generally deducted directly from the intangible asset account

• Straight-line Depreciation:

– Depreciation expense = (Original Cost – Salvage Value) / Useful Life




Super T-account

Assets

Liabilities

Contributed

Capital

Assets Liabilities & Shareholders’ Equity

Revenues

Retained Earnings

Dr.

+

Cr.

-

Dr.

-

Cr.

+

Dr.

-

Cr.

+

Cr.

+

Dr.

-

Cr.

+

Dr.

-

Cr.

-

Dr.

+

Expenses

Contra AssetsDr.

-

Cr.

+




What are the Journal Entries?1. September 30: BOC loans $100,000 to an employee at a 12% interest

rate.

2. December 31: End of the fiscal year, and no principal or interestpayments have been made yet.

3. January 6: The employee sends a check for three months of intereston the loan.




What are the Journal Entries?4. December 31: End of the fiscal year. During December, employees

earned $400,000 in salaries, but paychecks do not get issued unti lJanuary 2.

5. January 2: The paychecks are sent.




What are the Journal Entries?6. November 20: BOC pays $10,000 for December’s rent.

7. December 31: End of the fiscal year. Is an adjusting entry needed?If so, what is it?




What are the Journal Entries?8. June 30: A customer pays BOC $60,000 for a three-year sof tware

license.

9. December 31: End of the fiscal year. Is an adjust ing entry needed? Ifso, what is it?




What are the Journal Entries?10. June 30: BOC purchases a building for $500,000. The expected life

of the building is 20 years and its expected salvage value is$100,000.

11. December 31: End of the fiscal year: Is an adjusting entry needed?If so, what is it?




What are the Journal Entries?

12. December 31: BOC sti ll has an outstanding order for $300,000 ofproducts that wil l be delivered and bi lled in January.




Overview of Adjusting Entries

Dr. LiabilityCr. Revenue

Dr. ExpenseCr. Asset

AccountingRecognition

CashTransaction

Dr. CashCr. Liability

Dr. AssetCr. Cash

CashTransaction

Dr. Liabili tyCr. Cash

Dr. CashCr. Asset

Dr. ExpenseCr. Liability

Dr. AssetCr. Revenue

Deferred Revenue

Deferred Expense

Accrued Expense

Accrued Revenue




Relic Spotter Inc. Case• In the prior videos, we did all 20 transactions that occurred during its

first six-months of operations.

• Now, it is 5:00 pm on the last day of the fiscal year, December 31. We

will not record any more transactions with outsiders.• But, we have to record the internal transactions—adjusting entries—

before we can prepare financial statements.

• As in prior videos, we will record journal entries and post to t-

accounts for each adjust ing entry.• After each transaction is read, you should pause the video and try to

do the journal entry. Think about (1) what accounts are involved? (2)did they increase or decrease? (3) do we debit or credit?

• Then, resume the video to see the answer and the explanation.




Relic Spotter Inc. Case: Transaction 21• (21) When Park called her accountant on December 31, 2012, she was

pleased to tell him that the company had $79,000 in cash. Shewanted to go out to celebrate, but the accountant reminded her that

she needed to stay in to do adjusting entries. For example, eventhough it wasn’t paid in cash, accrued interest on the mortgage was$4,900.

•

Journal Entry




Relic Spotter Inc. Case: Transaction 22• (22) The accountant said that depreciation needed to be recorded on

the building (Park was confused by this because she received anunsolicited letter from a mortgage broker informing her that the

building had increased in value to $120,000).• Recall that, in transaction (5), Park renovated the building, bringing

its original cost to $85,000. She also determined that the useful l ife ofthe building was 25 years, with an expected salvage value of $10,000.

• Journal Entry




Relic Spotter Inc. Case: Transaction 23• (23) The accountant also noted that Park needed to record

depreciation on the Metal Detectors.

• Recall that, in transaction (6), Park purchased $120,000 of Metal

Detectors. She determined that the units would only last for twoyears, at which time they would have no remaining value.

• Journal Entry




Relic Spotter Inc. Case: Transaction 25• (25) …What about the prepaid advertising account?

• Recall that, in transaction (9), Park paid $8,000 upfront on June 30,2012 for advertising through June 30, 2013.

• Journal Entry




Relic Spotter Inc. Case: Transaction 26• (26) …What about the notes receivable account?

• Recall that, in transaction (10), Park borrowed $5,000 from RelicSpotter at 10% interest on June 30, 2012, with the principal and

interest due in a lump sum on June 30, 2013.

• Journal Entry




Relic Spotter Inc. Case: Transaction 27• (27) …What about the unearned revenue account?

• Recall that, in transaction (15), the Penn Antiquities Club paid RelicSpotter $1,200 cash upfront on December 1, 2012 for unlimited

rentals over the next year.

• Journal Entry




Relic Spotter Inc. Case: Transaction 28• (28) Finally, the accountant noted that Relic Spotter incurred an

estimated income tax expense of $630 for 2012 (Park was alsoconfused by this because she did not do her taxes until Apri l).

• Journal Entry





Analyze

Transactions

Journalizeand Post

Adjusting

Entries

Financial

Statements

During Period


Adjusted

Trial Balance

End of Period




Preparation of Financial Statements• Adjusted Trial Balance

– Summarizes balances in each account after adjust ing entr ies

– Used to make financial statements

• Preparation of Financial Statements – Prepare Income Statement first

– Then, use Net Income to update Retained Earnings and to prepare Balance

Sheet

– Finally, complete the Statement of Cash Flows and Statement of Stockholders’Equity




Income Statement FormatThe Income Statement generally has the following format:

Revenue (or Sales)

- Cost of Goods Sold

Gross Profit

- Operating (SG&A) Expense

Operating Income

- Interest, Gains, and Losses

Pre-tax Income

- Income Tax Expense

Net Income




Balance Sheet Format: Assets• Assets are listed f irst in the following order:

– Current assets (benefits within next year)

• Ordered by liquidity (how readily can they be converted to cash)

– Cash – Accounts Receivable

– Inventory

– Prepaid Assets

– Noncurrent assets

• Tangible assets• Intangible assets




Balance Sheet Format: Liabilities and Stockholders’ Equity• Liabilities and Stockholders’ Equity are listed second in the following

order:

– Current liabilities (obligations within next year)

• Ordered by liquidi ty – Bank borrowings

– Accounts payable and other payables

– Deferred revenues and other noncash

– Noncurrent liabilities

• Bank borrowings and bonds• Other types of liabilit ies (deferred taxes, pensions)

– Stockholders’ equity

• Contributed capital

• Retained earnings





Analyze

Transactions

Journalizeand Post

Adjusting

Entries

Financial

Statements

Closing

Entries

During PeriodStart new period


Adjusted

Trial Balance

End of Period




Close Temporary Accounts• Temporary Accounts

– Accumulate the effects of transactions for a period of time only

– Revenue and Expense accounts

– Closed out to retained earnings at the end of period

• Permanent Accounts

– Accumulate the effects of t ransactions over the entire life of business

– Balance sheet accounts (Assets, Liabil ities, Contributed Capital, Retained

Earnings)




Close Temporary Accounts• Closing entries

– Internal transactions that "zero out" temporary accounts at the end of the

accounting period

– Revenue and Expense account balances are transferred to Retained Earnings• Revenues: Dr. Revenue Accounts

Cr. Retained Earnings

• Expenses: Dr. Retained Earnings

Cr. Expense Accounts

• Post-closing trial balance – Summarizes balances of permanent accounts after closing entries

– All revenue and expense accounts have a zero balance

• Now, we’re ready to start the next fiscal period




Relic Spotter Inc. Case

• Prepare the Income Statement

• Record the closing entries and post to T-accounts

• Prepare the Balance Sheet

Week 2 - Accrual Accounting and the Income Statement.pdf

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Transcript of Week 2 - Accrual Accounting and the Income Statement.pdf