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Income Statement

Reports increase in shareholders equity due to operations over a period of time Income statement equation:
Net Income = Revenue Expenses Net income is also called earnings or net profit

All income statement items are based on Accrual Accounting principles

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Accrual Accounting
Accounting recognition of revenues and expenses are tied to business activities, not to cash flows Revenues are recognized when goods or services are provided (revenue recognition criteria) => Revenues Cash inflows Expenses are recognized in the same period as the revenues they helped to generate (matching principle) => Expenses Cash outflows => Net income Net cash flow

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Revenue
Revenue is an increase in shareholders equity (not necessarily cash) from providing goods or services. Revenue is recognized when both:
It is earned (i.e. goods or services are provided) and It is realized (i.e. payment for goods or services received in cash or something that can be converted to a known amount of cash)

These conditions are called revenue recognition criteria

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Expenses
Expenses are decreases in shareholders equity (not necessarily cash) that arise in the process of generating revenues Expenses are recognized when either:
Related revenues are recognized (product costs) or Incurred, if difficult to match with revenues (period costs and unusual events)

The underlying recognition concepts are the


Matching principle (product vs. period costs) Conservatism principle (unusual events): recognize anticipated losses immediately, recognize anticipated gains only when realized

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How Much Revenue Is Recognized in December?


1. BOC delivers $500,000 worth of washing machines in December to customers who dont have to pay until February.

2. BOC collects $300,000 cash in December for washing machines delivered in October.

3. BOC Realty 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.

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How Much Revenue Is Recognized in December?


4. BOC Aerospace receives an order for a $400,000 jet in December to be delivered in July.

5. BOC Bank is owed $100,000 of interest on a loan for December and receives the payment in January.

6. BOC issues 20,000 shares of stock in December and receives $10/share, which is $2/share more than they expected.

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How Much Expense Is Recognized in December?


1. BOC Automotive buys engines worth $2,000,000 in December for cash.

2. BOC Automotive uses the engines to make cars at a total cost of $10,000,000 in December.

3. BOC Automotive sells cars costing $8,000,000 in December for $15,000,000.

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How Much Expense Is Recognized in December?


4. BOC Automotive incurs $180,000 in salaries for its marketing staff in December.

5. BOC Automotive pays its auditor $50,000 in December for services to be rendered in December and January.

6. BOC Automotive pays $1,200,000 in cash dividends in December.

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Relic Spotter Inc. Case


In the prior video, we did the first 14 transactions for this start-up company. We will resume the case with transactions related to Revenues and Expenses. Some of the transactions will be summary entries to record sixmonths worth of activity. As we did last time, we will record journal entries and post to taccounts for each transaction. After each transaction is read, you should pause the video and try to do the journal entry. Think about (1) what accounts are involved? (2) did they increase or decrease? (3) do we debit or credit? Then, resume the video to see the answer and the explanation.

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Relic Spotter Inc. Case: Transaction 15


(15) In a search for new revenue opportunities, Park initiated an unlimited rental arrangement with the Penn Antiquities Club on December 1, 2012. Under this arrangement, the club paid Relic Spotter $1,200 cash upfront for unlimited rentals over the next year. Journal Entry

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Relic Spotter Inc. Case: Transaction 16


(16) For the six months ended December 31, 2012, rental revenues on the Metal Detectors totaled $124,300. Most of the rentals were paid in cash immediately. However, as an initiative to reward repeat customers, Park allowed a select number of frequent renters to charge their rentals and be billed later. As of December 31, 2012, $4,200 was outstanding under this plan. Journal Entry

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Relic Spotter Inc. Case: Transaction 17


(17) During the period between July 1 and December 31, Park purchased $40,000 of sundries inventory, of which $38,000 had been paid in cash and $2,000 was still owed at December 31. Journal Entry

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Relic Spotter Inc. Case: Transaction 18


(18) Relic Spotter recorded sales of sundries totaling $35,000 for the six months ended December 31, all received in cash.

Journal Entry

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Relic Spotter Inc. Case: Transaction 19


(19) The original cost of these sundries was $30,000. Journal Entry

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Relic Spotter Inc. Case: Transaction 20


(20) Finally, Relic Spotters two employees were paid wages of $32,000 total during this six-month period and Park drew a salary of $50,000.

Journal Entry

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The Accounting Cycle


Analyze Transactions During Period Journalize and Post End of Period Unadjusted Trial Balance

4. Unadjusted trial balance: Account balances are summed on a worksheet to verify that debits equal credits.

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Quick Review: The Accounting Cycle


Analyze Start new period Transactions During Period Closing Entries Journalize and Post End of Period Unadjusted Trial Balance Financial Statements Adjusting Entries

Adjusted Trial Balance

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Adjusting Entries
Adjusting entries
Internal transactions that update account balances in accordance with accrual accounting prior to the preparation of financial statements

Deferred Revenues and Expenses


Update existing account balances to reflect current accounting values Cash flow in past; record revenue/expense now

Accrued Revenues and Expenses


Create new account balances to reflect unrecorded assets or liabilities Record revenue/expense now; cash flow in future

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Deferred Expenses
Question: Are there any assets that have been used up this period and should be expensed? Examples:
Prepaid Rent Prepaid Insurance Depreciation or amortization
Property, plant, and equipment Intangible assets (e.g., Patents)

Journal Entry:
Dr. Expense Cr. Prepaid Asset

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Deferred Revenues
Question: Are there any liabilities that have been fulfilled by delivery of goods or services that should be recognized as revenue? Examples:
Unearned rental revenue Deferred subscription revenue

Journal Entry:
Dr. Unearned Revenue Liability Cr. Revenue

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Accrued Expenses
Question: Have any expenses accumulated during the period that have not yet been recorded? Examples:
Income Taxes Payable Interest Payable Salaries and Wages Payable

Journal Entry:
Dr. Expense Cr. Payable Liability

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Accrued Revenue
Question: Have any revenues accumulated during the period that have not yet been recorded? Examples:
Interest Receivable Rent Receivable

Journal Entry:
Dr. Receivable Asset Cr. Revenue

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Depreciation and Amortization


Allocate the original cost of a long-lived asset over its useful life
Matches the total expense (original cost) of asset to the revenues it generates over its period of use

Terminology
Tangible assets (physical assets) require depreciation Intangible assets (abstract assets) require amortization

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Depreciation and Amortization


Accounting Procedure
Depreciation is not deducted from the tangible asset account. Rather, it is recorded in a Contra Asset Account (XA) called Accumulated Depreciation, which
has a credit balance is subtracted from PP&E on the balance sheet to get the Net Book Value

Amortization is generally deducted directly from the intangible asset account

Straight-line Depreciation:
Depreciation expense = (Original Cost Salvage Value) / Useful Life

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Super T-account
Assets
Assets Dr. Cr. + -

Liabilities & Shareholders Equity


Liabilities Dr. Cr. + Contributed Capital Dr. Cr. +

Retained Earnings Contra Assets Cr. Dr. + Dr. Expenses

Cr. +
Revenues

Dr. +

Cr. -

Dr. -

Cr. +

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What are the Journal Entries?


1. September 30: BOC loans $100,000 to an employee at a 12% interest rate.

2. December 31: End of the fiscal year, and no principal or interest payments have been made yet.

3. January 6: The employee sends a check for three months of interest on the loan.

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What are the Journal Entries?


4. December 31: End of the fiscal year. During December, employees earned $400,000 in salaries, but paychecks do not get issued until January 2.

5. January 2: The paychecks are sent.

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What are the Journal Entries?


6. November 20: BOC pays $10,000 for Decembers rent.

7. December 31: End of the fiscal year. Is an adjusting entry needed? If so, what is it?

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What are the Journal Entries?


8. June 30: A customer pays BOC $60,000 for a three-year software license.

9. December 31: End of the fiscal year. Is an adjusting entry needed? If so, what is it?

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What are the Journal Entries?


10. June 30: BOC purchases a building for $500,000. The expected life of the building is 20 years and its expected salvage value is $100,000.

11. December 31: End of the fiscal year: Is an adjusting entry needed? If so, what is it?

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What are the Journal Entries?


12. December 31: BOC still has an outstanding order for $300,000 of products that will be delivered and billed in January.

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Overview of Adjusting Entries


Dr. Cash Cr. Liability Dr. Asset Cr. Cash Dr. Liability Cr. Revenue Dr. Expense Cr. Asset Deferred Revenue

Deferred Expense

Cash Transaction Accrued Expense

Accounting Recognition Dr. Expense Cr. Liability Dr. Asset Cr. Revenue

Cash Transaction Dr. Liability Cr. Cash Dr. Cash Cr. Asset

Accrued Revenue

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Relic Spotter Inc. Case


In the prior videos, we did all 20 transactions that occurred during its first six-months of operations. Now, it is 5:00 pm on the last day of the fiscal year, December 31. We will not record any more transactions with outsiders. But, we have to record the internal transactionsadjusting entries before we can prepare financial statements. As in prior videos, we will record journal entries and post to taccounts for each adjusting entry. After each transaction is read, you should pause the video and try to do the journal entry. Think about (1) what accounts are involved? (2) did they increase or decrease? (3) do we debit or credit? Then, resume the video to see the answer and the explanation.

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Relic Spotter Inc. Case: Transaction 21


(21) When Park called her accountant on December 31, 2012, she was pleased to tell him that the company had $79,000 in cash. She wanted to go out to celebrate, but the accountant reminded her that she needed to stay in to do adjusting entries. For example, even though it wasnt paid in cash, accrued interest on the mortgage was $4,900. Journal Entry

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Relic Spotter Inc. Case: Transaction 22


(22) The accountant said that depreciation needed to be recorded on the building (Park was confused by this because she received an unsolicited letter from a mortgage broker informing her that the building had increased in value to $120,000). Recall that, in transaction (5), Park renovated the building, bringing its original cost to $85,000. She also determined that the useful life of the building was 25 years, with an expected salvage value of $10,000. Journal Entry

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Relic Spotter Inc. Case: Transaction 23


(23) The accountant also noted that Park needed to record depreciation on the Metal Detectors. Recall that, in transaction (6), Park purchased $120,000 of Metal Detectors. She determined that the units would only last for two years, at which time they would have no remaining value. Journal Entry

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Relic Spotter Inc. Case: Transaction 24


(24) The accountant continuedWhat about adjusting the software amortization account? Recall that, in transaction (8), Park paid the $700 annual software license fee on June 30. Journal Entry

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Relic Spotter Inc. Case: Transaction 25


(25) What about the prepaid advertising account? Recall that, in transaction (9), Park paid $8,000 upfront on June 30, 2012 for advertising through June 30, 2013. Journal Entry

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Relic Spotter Inc. Case: Transaction 26


(26) What about the notes receivable account? Recall that, in transaction (10), Park borrowed $5,000 from Relic Spotter at 10% interest on June 30, 2012, with the principal and interest due in a lump sum on June 30, 2013. Journal Entry

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Relic Spotter Inc. Case: Transaction 27


(27) What about the unearned revenue account? Recall that, in transaction (15), the Penn Antiquities Club paid Relic Spotter $1,200 cash upfront on December 1, 2012 for unlimited rentals over the next year. Journal Entry

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Relic Spotter Inc. Case: Transaction 28


(28) Finally, the accountant noted that Relic Spotter incurred an estimated income tax expense of $630 for 2012 (Park was also confused by this because she did not do her taxes until April). Journal Entry

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The Accounting Cycle


Analyze Transactions During Period Journalize and Post End of Period Unadjusted Trial Balance Financial Statements Adjusting Entries

Adjusted Trial Balance

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Preparation of Financial Statements


Adjusted Trial Balance
Summarizes balances in each account after adjusting entries Used to make financial statements

Preparation of Financial Statements


Prepare Income Statement first Then, use Net Income to update Retained Earnings and to prepare Balance Sheet Finally, complete the Statement of Cash Flows and Statement of Stockholders Equity

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Income Statement Format


The Income Statement generally has the following format: Revenue (or Sales) Cost of Goods Sold Gross Profit Operating (SG&A) Expense Operating Income Interest, Gains, and Losses Pre-tax Income Income Tax Expense Net Income

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Balance Sheet Format: Assets


Assets are listed first in the following order:
Current assets (benefits within next year)
Ordered by liquidity (how readily can they be converted to cash)
Cash Accounts Receivable Inventory Prepaid Assets

Noncurrent assets
Tangible assets Intangible assets

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Balance Sheet Format: Liabilities and Stockholders Equity


Liabilities and Stockholders Equity are listed second in the following order:
Current liabilities (obligations within next year)
Ordered by liquidity
Bank borrowings Accounts payable and other payables Deferred revenues and other noncash

Noncurrent liabilities
Bank borrowings and bonds Other types of liabilities (deferred taxes, pensions)

Stockholders equity
Contributed capital Retained earnings

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The Accounting Cycle


Analyze Start new period Transactions During Period Closing Entries Journalize and Post End of Period Unadjusted Trial Balance Financial Statements Adjusting Entries

Adjusted Trial Balance

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Close Temporary Accounts


Temporary Accounts
Accumulate the effects of transactions for a period of time only Revenue and Expense accounts Closed out to retained earnings at the end of period

Permanent Accounts
Accumulate the effects of transactions over the entire life of business Balance sheet accounts (Assets, Liabilities, Contributed Capital, Retained Earnings)

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Close Temporary Accounts


Closing entries
Internal transactions that "zero out" temporary accounts at the end of the accounting period Revenue and Expense account balances are transferred to Retained Earnings
Revenues: Dr. Revenue Accounts Cr. Retained Earnings Expenses: Dr. Retained Earnings Cr. Expense Accounts

Post-closing trial balance


Summarizes balances of permanent accounts after closing entries All revenue and expense accounts have a zero balance

Now, were ready to start the next fiscal period

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Relic Spotter Inc. Case


Prepare the Income Statement Record the closing entries and post to T-accounts Prepare the Balance Sheet

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