THE INCOME STATEMENT AND ADJUSTING

ENTRIES
FINANCIAL ACCOUNTING – LECTURE 2

ERIC FLOYD– FALL 2017

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REVIEW
Balance Sheet at December 31, 2014

Cash + Noncash Assets = Liabilities + Contributed Capital + Retained Earnings

Cash flow statement explains

Income statement explains

Statement of Cash Flows Income Statement
For year ended, 12/31/2015 For year ended, 12/31/2015
this change

this change
(Change in cash from (Change in retained earnings
Dec. 31, 2014 to from Dec. 31, 2014 to
Dec. 31, 2015) Dec. 31, 2015)

Cash + Noncash assets = Liabilities + Contributed Capital + Retained Earnings

Balance Sheet at December 31, 2015

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REVIEW
The Basic Accounting Equation:

 Assets = Liabilities + Shareholders’ Equity

 ∆Assets =∆Liabilities + ∆Shareholders’ Equity

 ∆Assets = ∆Liabilities + ∆Cont. Capital + ∆Retained Earnings

 ∆Assets = ∆Liabilities + ∆Cont. Capital + Net Income – Dividends

 ∆Assets = ∆Liabilities + ∆Cont. Capital + Revenues - Expenses – Dividends

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TODAY’S TOPICS
Learning objectives:
 Understand accrual based accounting and why it provides measures of
operating performance that are superior to those provided by the cash
basis of accounting.

Topics covered:
 The income statement
• Accounting Periods (the time period assumption)
• Cash accounting versus accrual accounting
• Measurement principles of accrual accounting

 The accounting process

 Adjusting entries
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INCOME STATEMENT
 An economist would define income as change in shareholder wealth, i.e.,
change in market value of shareholder’s equity plus dividends received
over a period of time.

 Accountants define income by reference to specific identifiable events that

result in measurable elements of revenue and expenses.

 The difference between accounting and economic income is due to

accountants concerns of measurability and reliability.

Assets – Liabilities = Shareholder’s Equity

Income increases Income increases
net assets owners’ equity (net
worth) by the same
amount
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THE ACCOUNTING PERIOD

 Income generating activity occurs continuously

 Financial reports are prepared at the end of a period, e.g., quarters or

years
 Income statement measures flow of net assets
 Balance sheet measures the level of net assets (assets and liabilities)

 Uniform time periods facilitates comparisons across time

 Many companies use the end of the calendar year as the end of their
accounting period.
 Industry variation, e.g., retail
 Country variation, e.g., Germany and the UK
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NEED TO MEASURE PERFORMANCE ON
ACCRUAL BASIS
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DEFINITION FOR CASH AND ACCRUAL BASIS

 Cash basis of accounting
• Revenues are recognized when cash is received and expenses are
recognized when cash is paid.

 Accrual basis of accounting

• Revenues and expenses are recognized on an economic basis without
regard for the actual flow of cash.
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CASH BASIS OF ACCOUNTING

 Advantages:
• Intuitive and easy (low cost to produce financial statements)
• Provides reliable information about cash flows
• Provides information on the liquidity of a firm

 Disadvantages:
• Poor matching of resources incurred to benefits received
• Records expenses too quickly and revenue too slowly: need to wait
until cash changed hands
• Subject to manipulation, for example, the firm can delay having to
recognize an expense by postponing cash payment
• The longer the business cycle, the more deficient
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ACCRUAL BASIS OF ACCOUNTING

 More difficult conceptually.
 Economically, changes in wealth may occur without involving cash, for
example, a barter trade or a customer purchasing goods on account.
 Revenues and expenses are recognized independent of the timing of cash
flows.
 Advantages:
• Better measurement of performance (expenses more closely match
reported revenue)
• Less scope for timing manipulations.
 Disadvantages:
• Requires more estimates and assumptions (i.e., more costly)
• Subject to manipulation by the choice of recognition rules.
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QUESTIONS
 In lecture one we discussed that accounting is used for:
• Valuation of the firm and its securities
• Contracting (e.g., covenants in debt contracts)

 Do you think cash basis or accrual basis is best for these

purposes?

 Why?
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PURPOSE AND USE OF INDIVIDUAL REVENUE
AND EXPENSE ACCOUNTS
 Revenue and expense transactions could be recorded directly to the
Retained Earnings account.

 It is more informative to collect revenues and expenses separately during

the accounting period.

 At the end of the accounting period, revenues and expenses are cleared
(reset to zero) for the new accounting period. Their balances flow into
Retained Earnings. This process is called closing the accounts.
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REVENUE/EXPENSE ACCOUNTS AND
SHAREHOLDERS’ EQUITY
 One-side of revenue and expense transactions impacts the Retained Earnings account that belongs to the owners’ equity
group.
 It is more informative to collect this impact in separate “temporary” accounts during the accounting period.
 At the end of the accounting period, these revenue and expense temporary accounts are cleared (reset to zero) for the new
accounting period. Their balances flow into Retained Earnings. This process is called closing the accounts.
 Expense accounts have a normal debit balance before closing (reset to zero at end of accounting period).
 Revenue accounts have a normal credit balance before closing.
Expenses/Losses

Increases
Revenues/Gains
+ Retained Earnings (OE)

Dr. Increases
✓ BB
+

Dividends Cr.
Decreases Increases
Increases  +
+ Dr. Cr.
Dr. ✓ EB
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ADDING INCOME STATEMENT TRANSACTIONS TO
OPENING BALANCE FROM WEEK 1 HANDOUT
(SLIDES 49 - 52)
 Assume that there are only two transactions that affect the income
statement (very simple example but it illustrates the point):

8. The firm makes $20,000 cash sales to customers.

9. The associated cost of goods sold are $10,000 which are taken from
the merchandise inventory.

 Entries 2, 3, 4, and 5 result in adjusting entries but we will ignore those for
now (see later slides in this handout).
 On the slides from week 1 do the following:
 Create T-accounts and show the two entries
 Adjust the balance sheet and create an income statement
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CLOSING ENTRY EXAMPLE
Accounts (ending balances) Dr. Cr.
Revenue 1200
Cost of Goods Sold 600
Depreciation Expense 100
SG&A 60
Advertizing Expense 80
R&D Expense 120
Interest Expense 40

Closing Journal Entry

Dr. Revenue 1200

Cr. Cost of Goods Sold 600
Cr. Depreciation Expense 100
Cr. SG&A 60
Cr. Advertizing Expense 80
Cr. R&D Expense 120
Cr. Interest Expense 40
Cr. Retained Earnings 200 = Net Income
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REVENUE
 Revenue is an increase in net assets (not necessarily cash) in the period
between two balance sheet dates from providing goods or services (i.e.,
from operating activities). Revenue is also an increase in Retained
Earnings.

Two important issues:

 Timing of revenue recognition

 Measurement of revenue
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REVENUE - TIMING
 When does the accountant recognize revenue? What are the criteria?

 When the following are met:

• The firm has performed all or most of the services or it has delivered
the goods.
• Receipt of assets from the customer. The seller has received cash or
some other assets that it can convert to cash, for example, by
collecting an accounting receivable.

 Criterion 1 is concerned with whether revenue is earned and criterion 2

whether revenue is measurable.
 For most businesses, these conditions are met at the point of delivery of
goods and services, regardless of when cash is received.
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REVENUE - AMOUNT
 Revenues are measured by the cash or equivalent that it expects to receive.
Dr. Accounts Receivable (or Cash) (A) 1000
Cr. Revenue (RE) 1000
 Uncollectible accounts have no value by definition and are not included in revenue.
 Sales discounts and allowances are reductions in price and not included in revenue.
Dr. Cash (A) 980
Dr. Revenue (RE) 20
Cr. Accounts Receivable (A) 1000
 Sales returns are a reversal of the sale and are not included in revenue.
Dr. Revenue (RE) 50
Cr. Accounts Receivable (A) 50

 GAAP: In the end of the period, the company must estimate the amounts of
uncollectible amounts, sales discounts & returns and reduce revenue accordingly (more
detailed discussion in lecture 4).
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HOW MUCH REVENUE IS RECOGNIZED IN
DECEMBER?
 Best Buy delivers $500,000 worth of washing machines in December to
customers who don’t have to pay until February.

 Tyco collects $300,000 cash in December for toy sales made in October.

 Company leases space to a tenant for the months of December and January for
$20,000, all of which is paid for in cash in December.

 Boeing receives an order for a $400,000 jet in December to be delivered in

July.

 Peoplesoft issues 20,000 shares of stock in December and receives $10 per
share, which is $2 per share more than they expected.

 Enron sets up a pilot program with Blockbuster to deliver video on demand to

consumers, via a technology that doesn’t yet exist. They sell the next 10 years
of cash flow to CIBC for $115.2 million and guarantee the full value of the
investment if the venture fails to make money.
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BEST BUY, NOTE ON REVENUE RECOGNITION

“We recognize revenue, net of estimated returns, at the time the customer takes possession of
the merchandise or receives services. We estimate the liability for sales returns based on our
historical return levels.

We sell gift cards to customers in our retail stores, through our Web sites and through selected
third parties. A liability is initially established for the cash value of the gift card. We recognize
revenue from gift cards when: (i) the card is redeemed by the customer; or (ii) the likelihood of
the gift card being redeemed by the customer is remote ("gift card breakage"). We determine
our gift card breakage rate based upon historical redemption patterns, which show that after
24 months, we can determine the portion of the liability for which redemption is remote. Gift
card breakage income was as follows ($ in millions):

2014 2013 2012

$53 $46 $54
A 10% change in our gift card breakage rate at February 1, 2014, would have affected net
earnings by approximately $25 millions in fiscal year 2014.”
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EXPENSES
 Assets provide future benefits to the firm and are consumed in the process
of generating revenues.
 As assets are consumed, the value of the remaining asset is reduced and an expense
in incurred, thus, assets flow out of the firm as expenses.

 Accountants recognize expenses in the period when the firm benefits from
an asset, i.e., in two cases
1. If an asset expiration associates/matches directly with a revenue,
expense is recorded in the period when the revenue is recognized
(matching)
2. If an asset expiration does not clearly associate with revenues, expense
is recorded in the period in which a firm benefited from asset
consumption (period costs).

 The underlying recognition concept is called the matching principle.

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EXPENSE RECOGNITION EXAMPLES

 Product Costs -- the cost of making a product is not an expense until the
product is sold, then it becomes a cost of goods sold expense. Prior to this
time, the cost is the unexpired asset, inventory.
Dr. Cost of Goods Sold (or Cost of Sales) (RE) 500
Cr. Inventory (Finished Goods) (A) 500
 Administrative Costs -- cannot easily be matched with revenue, so are
considered a period cost.
 R&D Costs – expensed. IFRS gives more flexibility to capitalize these costs
after the point of technological feasibility.
 Marketing Costs -- may or may not give rise to an expense. Most
accountants prefer to expense marketing costs in the period when
incurred.
AICPA SOP 93-7, ¶ 26, requires that advertising costs generally be expensed either as they
are incurred or the first time advertising takes place. SOP 93-7, however, contains a narrow
exception for certain direct-response advertising costs.
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HOW MUCH EXPENSE IS RECOGNIZED IN
DECEMBER?
 GM buys engines worth $2,000,000 in December for cash.

 GM uses the engines to make cars at a total cost of $10,000,000 in

December.

 GM sells cars costing $8,000,000 in December for $15,000,000.

 GM incurs $180,000 in salaries for its marketing staff in December.

 GM pays a public relations consultant $50,000 in December for services

to be rendered in December and January.

 GM buys a $500,000 machine press on December 15. The machine

enters usage in January.

 GM pays $1,200,000 in cash dividends in December.

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THE ACCOUNTING PROCESS

 Journalizing routine transactions (KEY STEP)

 Posting to accounts
Until now we have focus on these.

=> We now have an unadjusted trial balance

 Adjusting Entries (update the accounts to reflect accrual process) (KEY

STEP)
=> We now have an adjusted trial balance
 Financial Statement Preparation
Recognition of transactions is discrete
while the revenue generating process is
continuous (e.g., interest, depreciation,
rent). Thus, we have to update the accounts
just before we prepare the financial
statements.
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ADJUSTING ENTRIES
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ACCRUED REVENUE
Papa John’s loaned $3,000 to franchisees on December 31 (one
month ago) at 6 percent interest per year with interest to be paid at
the end of each year. Notes Receivable (the principal) was recorded
properly when the money was loaned.

Adjusting entry for January:

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DEFERRED EXPENSES

Prepaid Expenses includes $2,000 paid on January 1 for insurance

coverage for four months (January through April).

Adjusting entry for January:

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SUMMARY
 The income statement which measures net income was presented.

 Revenues and expenses were defined and how they relate to retained
earnings was presented.

 Adjusting entries were defined as journal entries made at the end of an

accounting period to recognize revenues or expenses but are not initiated
by an economic event.

 Further chapters discuss the use of the income statement.