Notes

The Income Statement includes all revenues earned from sales to customers and the expenses incurred to produce those revenues: shows the outcome of business operations for which the firm makes investments and obtain financial resources and how it has been achieved.

To understand how business plans and the results of operations are reflected on the income statement, we need to answer the following questions:

• How do Business activities affect the income statement?

  • The Operating Cycle, begins when a company receives goods to sell, pays for them, and sells to customers; it ends when customers pay cash to the company. The length of time for completion of the operating cycle depends on the nature of the business. Yet, financial statements refer to a Fiscal Year. Hence, in most cases, the operating cycle lasts more than one year causing a not-perfect overlap between operating cycle and fiscal year to which financial statements refer. This creates two problems:
    • Recognition Issues, when should the effects of operating activities be recognized?
    • Measurement Issues, what amounts should be recognized?
  • Elements on the Income Statement
    • Revenues, increases in assets or settlements of liabilities from ongoing operations. Economic benefits generated by assets. Core Business.
    • Expenses, decreases in assets or increases in liabilities from ongoing operations. Core Business.
    • Gains, increases in assets or settlements of liabilities from peripheral transactions.
    • Losses, decreases in assets or increases in liabilities from peripheral transactions.

• How are Business Activities measured?

  • Accrual Accounting, revenues should be recognized when the transaction that causes them occurs, not necessarily when cash is paid or received
    • Revenue Principle, four criteria must be met for revenue to be recognized:
      • Delivery has occurred or services have been rendered.
      • There is persuasive evidence of an arrangement for customer payment.
      • The price is fixed or determinable.
      • Collection is reasonably assured.

• At this point, 3 situations may occur:

  • Cash is received before the goods or services are delivered; the liability account Unearned Revenue is recorded. When the company delivers the goods or services Unearned Revenue is reduced and Revenue is recorded.
  • Cash is received in the same period as the goods or services are delivered. Revenue is recorded.
  • Cash is received after the goods or services are delivered. An asset Accounts Receivable is recorded. When the cash is received the Accounts Receivable is reduced.
  • Matching Principle, resources consumed to earn revenues in an accounting period should be recorded in that period, regardless of when cash is paid. (Matching of costs with benefits).

• At this point, 3 situations may occur:

  • Cash is paid before the expenses is incurred to generate revenue. When revenues are generated in the future, the company records an expense for the portion of the cost of the assets used.
  • Cash is paid in the same period as the expense is incurred to generate revenue. Expenses are sometimes incurred and paid for in the period in which they arise.
  • Cash is paid after the cost is incurred to generate revenue. A liability Payable is recorded. When cash is paid the Payable is reduced.

• Cash Accounting, revenue is recorded when cash is received, and expenses are recorded when cash is paid.

The Expanded Transaction Analysis Model. We have discussed the variety of business activities affecting the income statement and how they are measured. Now we need to determine how these business activities are recorded in the accounting system and reflected in the financial statements. Previous sections covered investing and financing activities that affect assets, liabilities, and contributed capital. We now expand the transaction analysis model to include operating activities.

Adjusting and Closing Entries

The end of the accounting period is a very busy time for accountants. Although the last day of the fiscal year falls on the last day of December each year, the financial statements are not distributed to users until management and the external auditors (independent CPAs) make many critical evaluations.

• Management must ensure that the correct amounts are reported on the balance sheet and income statement. This often requires estimations, assumptions and judgments about the timing of revenue and expense recognition and values for assets and liabilities.
• The Auditors have to asses the strength of the controls established by management to safeguard the company's assets and ensure the accuracy of the financial records and evaluate the appropriateness of estimates and accounting principles used by management in determining revenues and expenses.

Managers of most companies understand the need to present financial information fairly so as not to mislead users. However, since end-of-period adjustments are the most complex portion of the annual record keeping process, they are prone to error.

Many operating activities take place over a period of time or over several periods, such as using insurance that has been prepaid or owing wages to employees for past work. Because recording these and similar activities daily is often very costly, most companies wait until the end of the period to make adjustments to record related revenues and expenses in the correct period. These entries update the records and are the focus of this chapter.

The accounting cycle is the process followed by entities to analyse and record transactions, adjust the records at the end of the period, prepare financial statements, and prepare the records for the next cycle. During the accounting period, transactions that result in exchanges between the company and other external parties are analysed and recorded in the general journal in chronological order (journal entries, and the related accounts are updated in the general ledger (T-Accounts). We are now examining the end-of-period steps that focus primarily on adjustments to record revenues and expenses in the proper period and to update the balance sheet accounts for reporting purposes.

Accounting systems are designed to record most recurring daily transactions, particularly those involving cash. As cash is received or paid, it is recorded in the accounting system. In general, this focus on cash works well, especially when cash receipts and payments occur in the same period as the activities that produce revenues and expenses. However, cash is not always received in the period in which the company earns revenue: likewise, cash is not always paid in the period in which the company incurs an expense.

How does the accounting system record revenues and expenses when one transaction is needed to record a cash receipt or payment and another transaction is needed to record revenue when it is earned or an expense when it is incurred? The solution to the problem created by such differences in timing is to record adjusting entries at the end of every accounting period, so that:

• Revenues are recorded when they are earned
• Expenses are recorded when they are incurred to generate revenues
• Assets are reported at amounts that represent the probable future benefits remaining at the end of the period.
• Liabilities are reported at amounts that represent the probable future sacrifices of assets and services owed at the end of the period.

Companies wait until the end of the accounting period to adjust their accounts in this way because adjusting the records daily would be very costly and time-consuming. Adjusting entries are required every time a company wants to prepare financial statements for external users.

In analysing adjustments at the end of the period, there are three steps:

• Was revenue earned or an expense incurred that is not yet recorded?
  • If the answers is YES, credit the revenue account or debit the expense account in the adjusting entry.
• Was the related cash received or paid in the past or will it be received in the future?
  • If cash was received in the past, a deferred revenue (liability) account was recorded in the past. Now, reduce the liability account (usually Unearned Revenue) that was recorded when cash was received because some or all of the liability has been earned since then.
  • If cash will be received in the future. Increase the Receivable Account (such as Interest Receivable or Rent Receivable) to record what is owed by others to the company (creating an Accrued Revenue)
  • If cash was paid in the past, a deferred expense account (asset) was created in the past. Now, reduce the asset account (such as Supplies or Prepaid Expenses) that was recorded in the past because some of or the entire asset has been used since then.
  • If cash will be paid in the future. Increase the payable account (such as Interest Payable or Wages Payable) to record what is owed by the company to others (creating an Accrued Expense)
  • Cash is never included in the adjusting entry because it was recorded already in the past or will be recorded in the future.
• Compute the amount of revenue earned or expense incurred. Sometimes the amount is given or known, sometimes it must be computed, and sometimes it must be estimated.

There exist four Types of Adjustments:

• Adjusting entries that Increase Revenues
  • Deferred or Unearned Revenues, previously recorded liabilities that were created when cash was received in advance and that must be reduced for the amount of revenue actually earned during the period.
  • Accrued Revenues, revenues that have been earned but not yet recorded because cash will be received after the services are performed or goods are delivered.
• Adjusting entries that Increase Expenses
  • Deferred or Prepaid Expenses, previously recorded assets, (such as Prepaid Rent, Supplies and Equipment), that were created when cash was paid in advance and that must be reduced for the amount of expense actually incurred during the period through use of the asset (Depreciation).
  • Accrued Expenses, expenses that have been incurred but not yet recorded because cash will be paid after the goods or services are used.