Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3

2005-2006 Income Statement

Fulbright Economics Teaching Program

Ho Chi Minh City, Vietnam
Academic Year: 2005-2006

Principles of Accounting

Lecture Notes 3a

INCOME STATEMENT

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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 year

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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

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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)

Permanent Liabilities (L)

Accounts
Owners’ Equity (OE):
Capital
Withdrawals

Temporary
Revenues (R)
Accounts
Expenses (E)

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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

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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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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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

Receivables

ƒ To secure the matching rule, revenues are also

recorded by adjusting accounts at the end of the
accounting period

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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
Cash Expense

Payables

ƒ Expenses are also recorded by adjusting accounts

at the end of the accounting period
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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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

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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

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

Deferred revenue: Collections from

customers have been received but
should be allocated over many periods

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
Cash 800
Advances from Customers 800
ƒ Suppose, by January 31, the firm has provided
services costing $400
ƒ Adjusting entry (a)
Advances from Customers 400
Revenues 400
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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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)
Rental Expense 500
Prepaid Rental 500
ƒ Similarly, with prepaid insurance on Jan 5, the
adjusting entry will be (c)
Insurance Expense 100
Prepaid Insurance 100
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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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

Stationery 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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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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

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Accrued expense: Disbursements have not

been made but should be accounted in
advance

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

Wages & Salaries Expenses

ƒ Salaries are paid on January

Friday after two-week
Mon Tue Wed Thu Fri Sat Sun
working, costing $1,000
ƒ Average salaries expense 1 2 3 4 5 6 7

is $100 per day 8 9 10 11 12 13 14

ƒ Salaries payments were 15 16 17 18 19 20 21
made on the 12th and 26th
of January 22 23 24 25 26 27 28

ƒ How about the next 29 30 31 1/2 2 3 4

payment?
5 6 7 8 9 10 11

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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

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

Work sheet

Transaction Adjusted Financial

Journal Ledger Trial Balance
Analysis Trial Balance Statements

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
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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

Uses of Work Sheet

Preparing
financial
statements

Closing
temporary
Recording accounts
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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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

Closing

Expense Income Summary Revenue

XXX XXX XXX XXXXX XXXXX XXXXX
XX
/ / / / / /

Withdrawals Capital
X X X XXXXXX

XX

/ / XXXXXXX

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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

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Fulbright Economics Teaching Program Principles of Accounting Lecture Notes 3
2005-2006 Income Statement

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

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