Accounting I - Chapter 4: the Income Statement

Accrual Adjustments: Note 2 key ideas here

1.) Accrual adjustments are used to record revenue or expenses when they occur prior to receiving or paying cash and to adjust corresponding balance sheet accounts. 2.) Each accrual adjustment involves one asset and one revenue account, or one liability and one expense account.

2 Notes on Accumulated Depreciation & Depreciation Expense using example C

1.) Accumulated Depreciation is a balance sheet account and Depreciation Expense is an income statement account. As a balance sheet account, Accumulated Depreciation will increase each year as it accumulates the depreciation of each period. In contrast, the income statement account, Depreciation Expense, will include the depreciation of only the current accounting year. 2.) By recording depreciation in Accumulated Depreciation, distinct from the Equipment account, you can report both the original cost of equipment and a running total of the amount that has been depreciated. This gives financial statement users a rough idea of how much of the asset's original cost (representing its original usefulness) has been used up as of the balance sheet date. In our example, approximately 1/24 ($400/$9,600) of the equipment's total usefulness has been used up as of September 30.

the Two Needed Closing Journal Entries

1.) Debit each revenue account for the amount of its credit balance, credit each expense account for the amount of its debit balance and record the difference in Retained Earnings. If you've done it correctly the amount credited to Retained Earnings should equal Net Income on the income statement 2.) Credit the Dividends account for the amount if its debit balance and debit Retained Earnings for the same amount

Deferral Adjustments: Note 2 key ideas here

1.) Deferral adjustments are used to decrease balance sheet accounts and increase corresponding income statement accounts 2.) Each deferral adjustment involves one asset and one expense account, or one liability and one revenue account

2 Groups of Adjustments

1.) Deferrals 2.) Accruals

The Closing Process Achieves Two Outcomes:

1.) Net Income (or loss) and dividends are transferred into Retained Earnings 2.) Zero balances are established in all income statement and dividend accounts. After the closing journal entries are prepared and posted, the balances in the temporary accounts are reset to 0 to start accumulating next year's interest

Additional Comments on Adjusting Journal Entries

1.) None of the adjusting journal entries affected the Cash account. Cash is never part of an accrual or deferral 2.) These adjusting entries affect one balance sheet and one income statement account

Deferral Adjustments

: we say an expense or revenue has been deferred if we have postponed reporting it on the income statement until a later period; i.e. the deferral adjustment involves reducing prepaid rent on the balance sheet and increasing Rent Expense on the Income Statement

Balance Statement

Like the other statements, the balance sheet is prepared from the adjusted trial balance, as shown in Exhibit 4.11. When preparing the balance sheet, watch out for three things. 1.) remember to classify assets as current if they will be turned into cash or used up within 12 months. Liabilities should be classified as current if they will be fulfilled (paid) within 12 months. 2.) note that Accumulated Depreciation and Accumulated Amortization are reported in the assets section (and are subtracted from the accounts to which they are contra-accounts). 3.) get the Retained Earnings balance from the statement of retained earnings, not from the adjusted trial balance. (The adjusted trial balance still reports the period's opening Retained Earnings balance.)

Deferral Adjustments: (e) Gift Card Received

Noodlecake accepted $100 of gift cards from customers as payment for game downloads.The unadjusted trial balance reports $300 of Deferred Revenue, which represents Noodlecake's obligation to honor gift cards previously issued to customers. By now accepting $100 of gift cards in exchange for game downloads this month, Noodlecake has fulfilled a portion of its obligation and has generated additional sales. Thus, a deferral adjustment is needed to reduce Deferred Revenue and increase Sales Revenue.

Deferral Adjustments: (a) Supplies Used during the Period

Noodlecake counts its supplies on hand on September 30. Of the supplies previously purchased for $600, only $250 are now on hand. Note: Expense Recognition Principle: requires an adjustment be made to report the cost of supplies used up this month as an expense (to match against revenues)

Accrual Adjustments: (h) Interest Expense Incurred but Not Yet Recorded

Noodlecake has not paid or recorded the $100 interest that it owes for this month on its note payable. Noodlecake incurs interest each month on its unpaid note payable to the bank. An adjustment is needed to record the Interest Expense relating to September and, because this interest has not yet been paid, the adjustment also must record a liability called Interest Payable.

Accrual Adjustments: (g) Wage Expense Incurred but Not Yet Recorded

Noodlecake owes $1,950 of wages to employees for work done in the last six days of September. Back in Chapter 3, Noodlecake paid employees $7,800 for work done through September 24 ($325 per day). As of September 30, six additional days of work have been completed at a cost of $1,950 (= $325 × 6). Although this amount will not be paid until October, the expense relates to work done (and revenues generated) in September, so the expense recognition principle ("matching") requires an adjustment be made to accrue the $1,950 of wages incurred and owed by Noodlecake, as follows. When these $1,950 of wages are paid in cash the following month, Noodlecake will decrease Salaries and Wages Payable (with a debit) and decrease Cash (with a credit). Accrual adjustments also may be required for other expenses, like property taxes and interest, if incurred and owed (but not yet recorded) during the current period. The adjusting journal entry required for each of these items would be similar to the one shown in (g), with an expense recorded (with a debit) and a liability increased (with a credit). For purposes of our Noodlecake example, we'll assume the only remaining expenses to record are accruals for interest (in h) and income taxes (in i), both of which are incurred this month but won't be paid until a later period.

Accrual Adjustments: (i) Income Taxes Incurred but Not Yet Recorded

Noodlecake pays income tax at an average rate equal to 20 percent of the company's income before taxes. Just like you, a corporation is responsible for income tax on the income it generates. Income tax is calculated by multiplying (1) the company's adjusted income (before income tax expense) by (2) the company's tax rate. To calculate adjusted income (before income tax), the following table starts with the unadjusted revenue and expense numbers from the unadjusted trial balance (Exhibit 4.4) and then includes the effects of adjustments to revenues and expenses. Multiply the adjusted income before income tax ($1,000) by the tax rate (20%) to get the amount of income tax for September ($200). Tip: Always calculate income tax expense after taking into account all other adjustments.

Accrual Adjustments: (f) Services Given by Revenue Not Yet Recorded

Noodlecake provided $3,250 of consulting services to other app developers in September, with payment to be received in October. Companies that provide accounting, consulting, or other services that span more than one month are unlikely to receive cash or bill customers until the services have been provided in full. In Noodlecake's case, some of its services have been provided in September but have not yet been recorded. Because these revenues and the right to collect them (Accounts Receivable) arise from work occurring in September, the revenue recognition principle indicates they should be recorded in September. Thus, an accrual adjustment is needed on September 30 to increase Accounts Receivable on the balance sheet and increase Service Revenue on the income statement. Other situations require accrual adjustments for revenue that has been generated but not yet recorded. For example, interest on investments is earned daily but typically is received in cash on a yearly basis, so each month an accrual adjustment is made to increase Interest Receivable and Interest Revenue for amounts earned but not yet recorded.

Post-Closing Trial Balance

Note: After the journal entries are posted, all temporary accounts should have 0 balances Note: to ensure no errors occurred during the closing process, you could prepare a post-closing trial balance Definition: prepared to check that debits equal credits and that all temporary accounts have been closed

Post-Closing Trial Balance Graphic Part 1

Note: Total debits on the post-closing trial balance don't equal the total assets on the balance sheet because Accumulated Depreciation and Accumulated Amortization (credit balances on the trial balance) are subtracted from assets on the balance sheet. Instead on the post-closing trial balance Accumulated Depreciation and Accumulated Amortization are added to the Credit side

Adjustment Effects on the Balance Sheet vs the Income Statement

Notice that for events in (a), (b), and the Self-Study Practice, the deferral adjustments have two effects: (1) they reduce the carrying value of assets on the balance sheet and (2) they transfer the amount of the reductions to related expense accounts on the income statement. This happens whether we're adjusting supplies, prepaid rent, or even long-term assets like buildings, equipment, and software.

Preparing the Income Statement & Statement of Retained Earnings

Prepare the income statement by creating the usual heading (who, what, when) and listing the names and amounts for each revenue and expense account from the adjusted trial balance, as shown on the right side of Exhibit 4.10. Notice that each major category of items on the income statement is subtotaled prior to computing net income for the period. Account balances from the adjusted trial balance are also used in the statement of retained earnings, as shown in Exhibit 4.10. Notice the amount coming from the adjusted trial balance is the beginning-of-year balance for Retained Earnings. This account balance doesn't yet include revenues, expenses, and dividends for the current period because they've been recorded in their own separate accounts. Eventually, we will transfer ("close") those accounts into Retained Earnings, but that's done only at the end of the year. For now, the Retained Earnings account on the adjusted trial balance provides the opening amount on the statement of retained earnings. The amount for Net Income on the next line of the statement of retained earnings comes from the income statement, and the Dividends number comes from the adjusted trial balance. Tip: the account Dividends is reported only on the statement of retained earnings

Deferral Adjustments: (d) Amortization Is Recorded for Use of Software

The app software developed for Noodlecake, estimated to have three years of usefulness, has now been used for one month at an estimated expense of $250. Because Noodlecake's app will eventually decline in popularity, its software has a limited period of usefulness. To show that some of this usefulness is used up this period, part of the cost of the app software needs to be transferred to an expense this period. To show this, Noodlecake will record the following deferral adjustment at the end of every month to report amortization as an expense on the income statement (Amortization Expense) and accumulate it in a contra asset account on the balance sheet (Accumulated Amortization).

Preparing the Income Statement & Retained Earnings

The balance for each account in the trial balance is reported only once on either the income statement, statement of retained earnings, or balance sheet. Typically, the income statement is prepared first because its final number, net income, flows into the statement of retained earnings, from which the ending balance then flows into the balance sheet.

Deferral Adjustments: (b) Rent Benefits Expired During the Period

Three months of rent were prepaid on September 1 for $7,200, but one month has now expired, leaving only two months prepaid at September 30.

Explain how adjustments affect financial results

Throughout this chapter, you have learned various adjustments that must be made to the accounting records when finalizing and preparing the financial statements. These adjustments help to ensure all revenues and expenses are reported in the period in which they are generated and incurred. As a result of these adjustments, the financial statements present the best picture of whether the company's business activities were profitable that period and what economic resources the company owns and owes at the end of that period. Without these adjustments, the financial statements present an incomplete and misleading picture of the company's financial performance.

Temporary Accounts

accounts that only track the current year's results and are then closed before the next year's activities are recorded. They include all revenues, expenses, and dividends.

Adjusting Journal Entries

adjustments are made at the end of each accounting period immediately prior to preparing an adjusted trial balance and financial statements. Adjustments are not made daily because it's more efficient to do them all at once at the end of each period

Adjustments

are made to the accounting records at the end of the period to ensure assets and liabilities are reported at appropriate times. These adjustments also ensure the related expenses are reported in the proper period, as required by the revenue and term-26expense recognition principles. Adjustments involve both income and balance sheet accounts.

How are Liabilities reported?

are reported as amounts owed at the end of the current period that will require a future sacrifice of resources

How are Assets reported?

are reported as amounts representing economic benefits that remain at the end of the current period

Closing Income Statement & Dividend Accounts

at the end of each year after all the year's transactions and adjustments are recorded, all revenue, expense, and dividends are "closed" by moving their balances to their permanent home in Retained Earnings. The Retained Earnings account, like all other balance sheet accounts is considered a permanent account.

Deferral Adjustments & Revenues

deferral adjustments can also involve revenues. For example. when GQ recieves cash for subscription services before it has delivered magazines to subscribers, this revenue is initially deferred as a liability on the balance sheet (in an account called Deferred Revenue.) The liability indicates the company's obligation to deliver magazines in the future. Later, when the company delivers the magazines, thereby fulfilling its obligation and earning the revenue, a deferral adjustment is made to reduce Deferred Revenue on the balance sheet and increase Service Revenue on the income statement.

the Expense Recognition or "matching" principle

expenses are recorded in the same period as the revenues to which they relate

Adjusted Trial Balance

is prepared to check that the accounting records are still in balance, after having posted all adjusting entries to the T-accounts. To prepare an adjusted trial balance, just copy the adjusted T-account balances into the debit or credit columns of the adjusted trial balance

Accrual Adjustments

needed when a company has earned revenue or incurred an expense in the current period but has not yet recorded it because the related cash will not be received or paid until a later period

the unadjusted trial balance

presents the unadjusted balances for every account, which will help you identify accounts that require adjustments

the Revenue Recognition Principle

revenues are recorded when (or as) the seller fulfills its performance obligation to the customer

Amortization definition

similar to depreciation, it is the concept that applies to using up long-term assets that lack physical substance and have a limited period of usefulness. Tip: Amortization is NOT reported for long-term assets that have an unlimited period of usefulness. For example, Noodlecake's logo will be useful indefinitely, so it is not amortized.

Permanent Accounts

the balance sheet accounts that carry their ending balances into the next accounting period. They include the retained earnings account, asset accounts, and liability accounts.

Deferral Adjustments: (c) Depreciation Is Recorded for Use of Equipment

the computer equipment which was estimated to last 2 years, has now been used for one month, representing an estimated expense of $400 The expense recognition principle ("matching") indicates that when equipment is used to generate revenues in the current period, part of its cost should be transferred to an expense account in that period. This process is referred to as depreciation, so an income statement account named Depreciation Expense reports the cost of equipment used in the current period. On the balance sheet, we reduce the amount reported for equipment, but we don't take the depreciation directly out of the Equipment account. Rather, a contra-account is created to track all the depreciation recorded against the equipment. This contra-account, named Accumulated Depreciation, is like a negative asset account that is subtracted from the Equipment account in the assets section of the balance sheet Tip: Recording depreciation for the use of long-lived assets is a lot like recording the use of supplies. The only difference is a contra-account is used so that a record of the original cost is maintained for long-lived assets throughout their long lives. In the following analyses, we use a small "x" to indicate a contra-account, so the notation for a contra-account for an asset is "xA." An increase in a contra asset account (+xA) decreases total assets on the balance sheet (−A).

Adjustment Analysis, Recording, and Summarizing

the first step, Analyze, involves determining the necessary adjustments to make to the accounting records. To complete this step, you need to know the balance currently reported as the balance, and finally figure out the adjustment that will take you from the current (unadjusted) balance to the desired (adjusted) balance

Closing Temporary Accounts

the last step of the accounting cycle is referred to as the closing process. It is performed at the end of each year after the financial statements have been prepared.