Net income is an essential aspect of good investment decisions. Investors know that any information they gather to help in predicting net income will lead to more profitable investments. Proper computation of net income requires considerable attention to be paid to the proper measurement of the two primary components of net income – revenues and expenses.In this section, we look at important principles behind reporting of revenues and expenses and at their effect on accounting.
A company records revenues when it sells its product or provides its service to a customer. For example, revenues are recorded when FedEx delivers a package, Reebok sells a pair of shoes, AMC Theatres sells a movie ticket, American Eagle sells a shirt, or GEICO provides insurance coverage.The revenue recognition principle states that we should recognize revenue in the period in which we earn it, not necessarily in the period in which we receive cash.The matching principle recognize expenses in the same period as the revenues they help to generate. There is a cause-and-effect relationship between revenue and expense recognition implicit in this principle.
The cost of generating revenue in April (ship supplies, the fuel used, and crew members’ salaries) should be expensed in April even though the cash outflows occur in March, April, or May.Most expenses are recognized in the same period as the revenues they help to generate. Other expenses indirectly related to producing revenues are recognized in the period they occur.
We record revenues when we earn them (the revenue recognition principle) and not necessarily when we receive cash.We record expenses with related revenues (the matching principle) and not necessarily when we pay cash.Under accrual-basis accounting, we record revenue and expense transactions at the time the earnings-related activities occur.Under cash-basis accounting, we record revenues at the time we receive cash and expenses at the time we pay cash.
Here, you can see the timing differences between when revenue is recorded under accrual basis and cash basis.
Here, you can see the timing differences between when expenses are recorded under accrual basis and cash basis.
In Chapter 2, we started the measurement process of the accounting cycle by recording and posting external transactions that occurred during the period. In this chapter, we will complete the accounting cycle process.
The accounting cycle starts with recording of external transactions. In this chapter, we complete the accounting cycle by recording adjusting entries (internal transactions), preparing financial statements, and recording closing entries.
Adjusting entries are needed when cash flows or obligations occur before the earnings-related activity (prepayment) or when cash flows occur after the earnings related activity (accrual).Adjusting entries are grouped into two broad categories: prepayments and accruals.Prepayments (also called deferrals)Prepaid expenses—We paid cash (or had an obligation to pay cash) for the purchase of an asset before we incurred the expense.Unearned revenues—We received cash and recorded a liability before we earned the revenue.AccrualsAccrued expenses—We paid cash after we incurred the expense and recorded a liability.Accrued revenues—We received cash after we earned the revenue and recorded an asset.
Adjusting entries are a necessary part of accrual-basis accounting. They help to record revenues in the period earned and expenses in the period they are incurred to generate those revenues. Another benefit is that, by properly recording revenues and expenses, we correctly state assets and liabilities.
Prepaid expenses are the costs of assets acquired in one period that will be expensed in a future period (like the insurance coverage mentioned previously). The cash outflow (or obligation to pay cash, in the case of assets bought on account) from the purchase of an asset occurs before we record the expense.The adjusting entry for a prepaid expense always includes a debit to an expense account (increase an expense) and a credit to an asset account (decrease an asset).
Dec. 1: Pay one year of rent in advance, $6,000 ($500 per month).
Unearned revenues occur when a company receives cash in advance from a customer for products or services to be provided in the future.The adjusting entry for an unearned revenue always includes a debit to a liability account (decrease a liability) and a credit to a revenue account (increase a revenue).
Dec. 23: Eagle receives $600 in advance from customers who will be given 12 golf lessons ($50 per lesson) in the future.
When a company has a cost but hasn’t yet paid cash or recorded an obligation to pay for that cost, it still should record the cost as an expense and also a liability for the amount owed. This is referred to as an accrued expense. A few examples are accrued salaries, accrued interest, accrued utility costs.The adjusting entry for an accrued expense always includes a debit to an expense account (increase an expense) and a credit to a liability account (increase a liability).
Dec. 31: Eagle receives a utility bill for $900 associated with operations in December. Eagle plans to pay the bill on January 6. Even though it won’t pay the cash until January, Eagle must record the utility costs for December as an expense in December. The firm records the corresponding obligation to the utility company at the same time.
Accrued revenues refer to revenue that has been earned but hasn’t yet received cash or recorded an amount receivable. Such revenue should be recorded as an asset for the amount expected to be received.The adjusting entry for an accrued revenue always includes a debit to an asset account (increase an asset) and a credit to a revenue account (increase a revenue).
Eagle provides $700 of golf training to customers from December 28 to December 31. However, it usually takes Eagle one week to mail bills to customers and another week for customers to pay. Therefore, Eagle expects to receive cash from these customers during January 8–14. Because Eagle earned the revenue in December (regardless of when cash receipt takes place), Eagle should recognize in December the service revenue and the amount receivable from those customers.Adjusting entries are unnecessary in two cases: (1) for transactions that do not involve revenue or expense activities and (2) for transactions that result in revenues or expenses being recorded at the same time as the cash flow.
To complete the measurement process, we need to update balances of assets, liabilities, revenues, and expenses for adjusting entries.After we have posted the adjusting entries to the general ledger accounts, we’re ready to prepare an adjusted trial balance. An adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries.
Here is the adjusted trial balance of Eagle Golf Academy. It includes the adjusted balances of all general ledger accounts of Eagle after adjustments.
Once the adjusted trial balance is complete, we prepare financial statements.
This illustration describes the relationship between the adjusted trial balance and the financial statements. Notice the color coding of the accounts, to indicate their relationships to the financial statements.
Revenue and expense accounts are reported in the income statement. The difference between total revenues and total expenses equals net income.
The statement of stockholders’ equity summarizes the changes in each stockholders’ equity account as well as in total stockholders’ equity and the accounting value of the company to stockholders (owners).
The balance sheet you saw in an earlier chapter contained the key asset, liability, and stockholders’ equity accounts, presented as a rather simple list. This is a classified balance sheet. A classified balance sheet groups a company’s asset and liability accounts into several standard categories.Assets are separated into two major categories: Current assets—those that provide a benefit within the next year.Long-term assets—those that provide a benefit for more than one year.Liabilities are divided into two major categories:Current liabilities—those that are due within the next year.Long-term liabilities—those that are due in more than one year.
The final financial statement we need to prepare is the statement of cash flows. The statement of cash flows measures activities involving cash receipts and cash payments, reflecting a company’s operating, investing, and financing activities.
Closing entries transfer the balances of all temporary accounts (revenues, expenses, and dividends) to the balance of the Retained Earnings account.Here’s how:All revenue accounts have credit balances. To transfer these balances to the Retained Earnings account, we debit each of these revenue accounts for its balance and credit Retained Earnings for the total.Similarly, all expense and dividend accounts have debit balances. So, we credit each of these accounts for its balance and debit Retained Earnings for the total.
We can transfer the balances of all revenue, expense, and dividend accounts to the balance of the Retained Earnings account with the closing entries shown in this illustration.
The post-closing trial balance is a list of all accounts and their balances at a particular date after we have updated account balances for closing entries. The post-closing trial balance helps to verify that we prepared and posted closing entries correctly and that the accounts are now ready for the next period’s transactions.
This illustration shows the post-closing trial balance for Eagle Golf Academy as of December 31.