Principles of Accounting

by Nguyen Bao LinhMeasuring the Business Performance Net Income NI = Revenues R – Expenses E ƒ Revenues: the price of products, merchandise, and services supplied by a firm to its custom

Principles of Accounting

Fulbright Economics Teaching Program

Ho Chi Minh City, Vietnam

Academic Year: 2005-2006

INCOME STATEMENT

Lecture Notes 3a

by Nguyen Bao Linh

Measuring the Business Performance

Net Income (NI) = Revenues (R) –

Expenses (E)

ƒ Revenues: the price of products, merchandise, and services supplied by a firm to its customers during a certain period

ƒ Expenses: the cost of products, merchandise, and services used by a firm during a certain period

by Nguyen Bao Linh

Methods of Recognition

ƒ The accrual basic recognizes the impacts

of transactions on the financial statements when revenues and expenses occur regardless whether cash changes hands

ƒ The cash basis only records transactions when cash is disbursed or received

by Nguyen Bao Linh

Accounting Period

ƒ To periodically provide information to users, the firm’s operating process is allotted into relatively equal period, called accounting period

ƒ The length of an accounting period may

be a month, a quarter, or a year One-year length is called a fiscal One-year

Accounting Period

ƒ A fiscal year is not necessarily a calendar year The end of a fiscal year may not coincide with the harvest in order to

– Lessen the accountant’s work at the end of the period

– Simplify the inventory work – Reduce the workload of allocating revenues and expenses over various periods to account profits accurately

by Nguyen Bao Linh

Permanent and Temporary Accounts

ƒ A temporary account is the one that will

be closed (its balance equals zero) at the end of the accounting period to be

prepared for recording in the next period

ƒ A permanent account is not closed at the end of period; its ending balance

becomes the beginning one for the next period

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Permanent and Temporary Accounts

Assets (A) Liabilities (L)

Owners’ Equity (OE):

Capital Withdrawals Revenues (R) Expenses (E)

Permanent Accounts

Temporary Accounts

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Matching Rule

ƒ Revenues are recognized in an accounting period during which the firm provides products, merchandise, and services to customers

ƒ Expenses that are recognized in an accounting period must been used up during that period to generate the period revenues

Going-concern Rule

ƒ Firms are assumed to be continuously and indefinitely operating unless there is

evidence on bankruptcy or stopping business

ƒ This assumption allows accountants to simplify their calculation and allocation of revenues and expenses over more than one period such as

– Deferred Revenue – Depreciation of Fixed Assets

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Revenue Recognition

ƒ Revenues are recognized when goods and/or services are delivered to customers regardless whether collections have been made

ƒ To secure the matching rule, revenues are also

recorded by adjusting accounts at the end of the accounting period

Receivables

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Expense Recognition

ƒ Expenses recognized under the matching rule must involve in products, merchandise, or services that have been used to generate the period revenues, regardless whether cash changes hands

ƒ Expenses are also recorded by adjusting accounts

at the end of the accounting period

Expense Cash

Payables

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Adjustments to the Accounts

ƒ Adjustments are made through the adjusting entries at the end of each period

ƒ The purpose of adjustments is to fully account revenues and expenses for an accurate profit measurement

ƒ Only revenues and expenses involved in more than one period are adjusted

ƒ An adjusting entry is always related to a permanent and a temporary account Hence, an adjusting entry affects both balance sheet and income statement

Types of Adjustments

1. Deferred revenue (Unearned revenue):

Collections from customers have been received but should be allocated over many periods

2. Accrued revenue: Collections have not been received but should be accounted in advance

3. Deferred expense: Disbursements have been made but should be allocated over many periods

4. Accrued expense: Disbursements have not been made but should be accounted in advance

Deferred revenue: Collections from customers have been received but should be allocated over many periods

by Nguyen Bao Linh

Adjustment to Revenues

ƒ See the example in the previous lecture notes

ƒ January 18, the firm receives advances from customers for advertising services on real estate costing $800; a journal entry has been made

Advances from Customers 800

ƒ Suppose, by January 31, the firm has provided services costing $400

ƒ Adjusting entry (a)

Advances from Customers 400

Deferred expense: Disbursements have been made but should be allocated over many periods

Prepaid Expense

ƒ See the example, on January 1, the firm advances a rental of $3,000 for 6 month use

ƒ On Jan 31, $500 out of this amount is regarded

as “expired” and should be recognized by an adjusting entry (b)

ƒ Similarly, with prepaid insurance on Jan 5, the adjusting entry will be (c)

Insurance Expense 100 Prepaid Insurance 100

by Nguyen Bao Linh

Cost of Supplies

ƒ Suppose that an ending-period inventory reveals a stationery balance of $200

ƒ Hence, the portion of stationery used during period is $800 - $200 = $600

ƒ Adjusting entry (d)

Stationery Expense 600

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Depreciation Expense

ƒ Depreciation expense is the cost of long-term or fixed assets

ƒ Depreciation expense is calculated based on the value of the asset and its estimated usable life

ƒ There are many methods to account depreciation; the most commonly used is the straight line depreciation method

ƒ The going concern rule is applied in accounting depreciation

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Depreciation Expense

ƒ Suppose that the office equipment is depreciated under the straight-line method and has a usable life of 5 years (60 months)

ƒ The depreciation expense is $6,000 ÷ 60 = $100 for each month

ƒ Adjusting entry (e)

Depreciation Expense of Equipment 100 Accumulate Depreciation of Equipment 100

Accrued expense: Disbursements have not been made but should be accounted in

advance

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Wages & Salaries Expenses

ƒ Salaries are paid on Friday after two-week working, costing $1,000

ƒ Average salaries expense

is $100 per day

ƒ Salaries payments were made on the 12th and 26th

of January

ƒ How about the next payment? 295 306 317 1/28 92 103 114

28 27 26 25 24 23 22

21 20 19 18 17 16 15

14 13 12 11 10 9 8

7 6 5 4 3 2 1

Sun Sat Fri Thu Wed Tue Mon

January

by Nguyen Bao Linh

Wages & Salaries Expenses

ƒ Recording salaries payment on Feb 9 as usual is not reasonable, because it

includes 3-day salaries (the 29th, 30th, &

31st) of Jan costing $300 in the Feb wages expense

ƒ An adjusting entry (f) is necessary

Salaries Expense 300 Salaries Payable 300

Work sheet

Transaction Analysis Journal Ledger Trial Balance Trial BalanceAdjusted StatementsFinancial

Preparing a Work Sheet

1. Take balances from ledger accounts and enter them into “Trial Balance” column

2. Make necessary adjustments in “Adjustment”

column

3. Calculate adjusted balances on accounts and enter them into “Adjusted Trial Balance”

4. Transfer revenue and expense balances into

“Income Statement” column, other balances into “Balance Sheet,” and then balance them to calculate profits

by Nguyen Bao Linh

Uses of Work Sheet

Preparing financial statements

Closing temporary accounts

Recording adjusting entries

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Closing Temporary Accounts

ƒ Temporary accounts must be closed at the end of the period to be prepared for

recording in the next period

ƒ Temporary accounts include

– Revenues – Expenses – Withdrawals

ƒ Closing can be directly done or through the Income Summary Account

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Closing

Revenue Expense

Capital

Income Summary

Withdrawals

XXX XXX XXX XXXXX XXXXX XXXXX

XX

XX XXXXXXX / /

Post-closing Trial Balance

ƒ After closing, only permanent accounts have balances, including

– Assets – Liabilities – Owners’ Equity

ƒ Balances on these accounts will be the beginning balances for the next periods;

an accounting cycle has been closed, and

a new one starts

by Nguyen Bao Linh

References

ƒ Financial accounting – Clyde P

Stickney; Roman L Weil

ƒ Accounting – Charles T Horngren;

Walter T Harrison; Linda Smith Bamber

ƒ Principles of accounting – Belverd E

Needles, Jr.; Henry R Anderson; James C

Caldwell