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Lecture 4

Lecture 4. Income Statement: Cash versus Accrual Accounting. Firm of the Day. Goals of Today’s Class. Better understanding of Revenues and Expenses Better understanding of the Income Statement Better understanding of cash versus accrual accounting. Asset. Liability or Owners’ Equity.

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Lecture 4

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  1. Lecture 4 Income Statement: Cash versus Accrual Accounting

  2. Firm of the Day

  3. Goals of Today’s Class • Better understanding of Revenues and Expenses • Better understanding of the Income Statement • Better understanding of cash versus accrual accounting

  4. Asset Liability or Owners’ Equity (Debit) (Credit) (Debit) (Credit) Expenses/Losses Revenues/Gains (Debit) (Credit) Review: Debits and Credits Remember RE is an Owners’ Equity Account Retained Earnings + - - + Memorize this for Assets Flip it for Liabs + OE An increase in an Expense is a decrease in Retained Earnings. (We decrease Owners’ Equity accounts with a debit.) An increase in a Revenue is an increase in Retained Earnings. (We increase Owners’ Equity accounts with a credit.) + +

  5. Review of Shareholders’ Equity • What is “contributed capital”? • The initial investment of owners • e.g., common stock • What is “retained earnings”? • The cumulative net income of the company that has not been distributed as dividends.

  6. Peeking Ahead -- Contributed Capital: Common Stock Accounting for initial public issuance of common stock • Very simple if stock has no par value 1. Debit Cash for the amount of the contribution 2. Credit Common Stock for the amount of the contribution Example: Sell 2,000 shares of “no par common” for $8 per share (Debit) Cash $16,000 (Credit) Common Stock $16,000

  7. Peeking Ahead -- Contributed Capital: Common Stock Accounting for initial public issuance of common stock • More complicated if stock has a stated par value 1. Debit Cash for the amount of the contribution 2. Credit Common Stock for par value only 3. Credit Other Paid in Capital for the difference (contribution – par value) Example: Sell 2,000 shares of “$1 par common” for $8 per share (Debit) Cash $16,000 (Credit) Common Stock (2,000 shs. @ $1 par) $2,000 (Credit) Other Paid in Capital $14,000

  8. Balance Sheet Equation At = Lt + SEt At = Lt + CSt + APICt +REt At-1 = Lt-1 + CSt-1 + APICt-1 +REt-1 (At -At-1)= (Lt -Lt-1 )+ (CSt - CSt-1 )+ ( APICt - APICt-1 )+ ( REt - REt-1 ) ∆A = ∆L + ∆CS + ∆APIC + ∆RE ∆A = ∆L + ∆CS + ∆APIC + Net Income - Dividends ∆A = ∆L + ∆CS + ∆APIC + Revenue - Expenses- Dividends

  9. Income Statement • Reports Net Income earned by the business over a period of time as a result of its profit-directed activities. • Changes in shareholders’ equity due to profit-directed activities during an accounting period. • Income statement accounts are temporary accounts. • Net Income = Revenues – Expenses

  10. Accrual Accounting Goal is to account for all transactions that economically occurred in the pd. To document fundamental economics, we employ the accrual method The accrual method is best contrasted with the cash method of accounting through an example: On December 29th, Best Buy sells and delivers an HDTV worth $2,000 Customer purchases the TV using 6 month financing Best Buy prepares its income statement and balance sheet on December 31st (this assumes a December fiscal year end) Did the sale officially occur in the period even though no cash was received? Cash basis: No. Accrual Basis: Yes.

  11. Accrual Accounting (continued) To properly account for periodic income, recognize revenues when earned and expenses when incurred, even though no cash has been exchanged This concept is sometimes called the “matching principle”, where revenues are matched with expenses in the period in which they are incurred e.g., salaries are often not paid to employees until a week or two after employees have provided their services At the end of a period, firms must recognize earned, yet still unpaid, salary expense to correctly match the expense to the period in which the services were actually used To allow for proper accounting of revenues and expenses, we employ two temporary holding accounts called Receivables and Payables When revenues are earned, but no cash is received, we record an increase to a Receivable to reflect cash that we are owed in the future When expenses are incurred, but no cash is paid, we record an increase to a Payable to reflect cash that we owe in the future

  12. When and how do we identify and measure revenues and expenses? Timing • Cash Basis REVENUES with the increase in cash resulting from the sale of goods or services, and EXPENSES with the decrease in cash associated with sales activities. Purchase inventory for resale, on credit, Cost = $10 Sell and deliver inventory on credit, Price = $20 Pay supplier $10 Collect $20 from customer

  13. Calculating Net Income using Cash Basis Accounting 0 0 0 -10 0 10 0 0 0 +20 20 0

  14. What is the downside to Cash Basis Accounting? • Reflects the cost and benefit of operating transactions only when cash payments and cash receipts occur: - Delay in recognizing revenues until cash is received, despite the fact that the store has performed its primary mission: sale of inventory. - Poor matching of the true costs of generating revenues to the periods in which they are generated.

  15. 2. Accrual Basis - Revenues • Revenues and expenses are not necessarily associated with the cash inflows and cash outflows. • Identification: Revenue is the increase in assets (not necessarily cash) and/or decrease in liabilities resulting from the principal income generating activities of the business -- selling goods or services in the ordinary course of business.

  16. Timing (Recognition): Revenues:Benefits earned by an entity when the following criteria are satisfied: 1. The entity has delivered its goods/services to the customer. • There is persuasive evidence of an arrangement for customer payment. • The price is fixed or determinable. • Collection of cash (or other benefits) is reasonably assured, though there may still be some uncertainty (uncollectible accounts, warranties). The degree of uncollectability should be estimated with reasonable reliability. • Revenue is recorded according to the revenue principles, regardless of when cash is received!

  17. 2. Accrual Basis - Expenses • Revenues and expenses are not necessarily associated with the cash inflows and cash outflows. • Identification Expense is a decrease in assets (not necessarily cash) and/or an increase in liabilities, in a period, for the purpose of generating revenue in the period

  18. Timing (matching) Expenses are recognized • When the associated revenue is recognized • Matched to the timing of revenue • Reported in the income statement in the same period as the revenue they gave rise to. • “Matching principle”: recognize costs and/or assets used as expenses in the period in which they produce revenue • Goal of accrual accounting: report inflows of assets when they are earned, and net them against outflows of assets used to generate them

  19. Calculating Net Income using Accrual Basis Accounting 0 0 0 0 0 0 10 20 10 0 0 0

  20. Cash vs. Accrual basis of accounting: Summary • Cash basis of accounting: Method of accounting where income is calculated by recording revenues when cash is received and expenses when expenditures occur • Accrual basis of accounting: Method of accounting where income is calculated by recording revenues when benefits are earned and expenses when resources are given up to produce the revenues (expenses are matched to revenues)

  21. Please note that… • The aggregate net income over the life of the business is the same for accrual and cash basis accounting, and is equal to cash inflows minus cash outflows. The only difference is one of timing. • Cash basis – recognition of revenues and expenses are associated with the cash flows of the period. • Accrual basis – timing of cash flows is not necessarily associated with the recognition of revenues and expenses. • Cash may be received/paid before, during, or after revenue and expense recognition.

  22. Active vs. Passive Journal Entries Generally, two types of journal entries Active: generated by an actual transaction on the transaction date ABC Corp pays $12,000 to prepay 1 year’s rent (Debit) Prepaid Rent $12,000 (Credit) Cash $12,000 Passive: generated by an end-of-period required adjustment to update an account for a change due to passage of time 1 month elapses. ABC Corp must adjust the Prepaid Rent account to reflect time passage. (Debit) Rent Expense $1,000 (Credit) Prepaid Rent $1,000 Notice the difference: Active transactions are those made by the firm in the conduct of business Passive transactions are those made to update the status or balance of accounts that typically were created previously by active transactions

  23. Prepaid Rent 12,000 Without an adjustment as time passes, this amount would stay here (and on the balance sheet) forever Active vs. Passive Journal Entries (continued) If we did not make passive or adjusting entries, our accounts would stay stuck on the original entry and would therefore be inaccurate ABC Corp pays $12,000 to prepay 1 year’s rent (Debit) Prepaid Rent $12,000 (Credit) Cash $12,000

  24. Prepaid Rent 12,000 11,000 (Debit) Rent Expense $1,000 (Credit) Prepaid Rent $1,000 Active vs. Passive Journal Entries (continued) If we did not make passive or adjusting entries, our accounts would stay stuck on the original entry and would therefore be inaccurate ABC Corp pays $12,000 to prepay 1 year’s rent (Debit) Prepaid Rent $12,000 (Credit) Cash $12,000 1,000 So at regular time intervals, we make necessary passive adjustments 1 month elapses. ABC Corp must adjust the Prepaid Rent account to reflect time passage.

  25. Active vs. Passive Journal Entries (continued) Typical passive entries include adjustments for: Interest owed but not yet paid Interest earned but not yet received Rent owed but not yet paid Rent earned but not yet received Salaries earned but not yet paid Systematic depreciation of assets through time Systematic use or expiration of assets through time (like prepaid rent or drilling rights)

  26. Basic Accounting Flow Example Balance Sheet Accounts Self-Smart Corp receives $100,000 cash from owners to start the business Cash Contrib Cap 100,000 100,000 20,000 (Debit) Cash $100,000 40,000 (Credit) Contributed Capital $100,000 Self-Smart Corp buys one inventory item for $20,000 cash Inventory 20,000 (Debit) Inventory $20,000 20,000 (Credit) Cash $20,000 Self-Smart Corp sells the inventory item for $40,000 cash (Debit) Cash $40,000 (Credit) Sales Revenue $40,000 Income Statement Accounts (Debit) Cost of Goods Sold (Expense) $20,000 Cost of Goods Sold Sales Revenue (Credit) Inventory $20,000 20,000 40,000 End of Period—Prepare Financial Statements

  27. Basic Accounting Flow Example Balance Sheet Accounts Income Statement Cash Contrib Cap Revenues 40,000 100,000 100,000 - Expenses 20,000 20,000 40,000 = Net Income 20,000 Inventory 20,000 20,000 Income Statement Accounts Cost of Goods Sold Sales Revenue 20,000 40,000

  28. 20,000 Basic Accounting Flow Example Balance Sheet Accounts Balance Sheet Cash Contrib Cap 100,000 100,000 Assets Liabilities 20,000 Cash 120,000 0 40,000 Inv 0 120,000 100,000 Owners’ Equity Inventory Retained Earns Contrib Cap 100,000 Ret Earns 20,000 20,000 20,000 40,000 20,000 0 Income Statement Accounts Cost of Goods Sold Sales Revenue 20,000 20,000 40,000 40,000 0 0

  29. An Extended Example

  30. Balance Sheet Income Statement Cash Common Assets Liabilities Revenues/Gains 100,000 Expenses/Losses Equity 100,000 Jan 1: Received $100,000 in exchange for 10,000 shares of common stock (Debit) Cash $100,000 (Credit) Common Stock $100,000

  31. Balance Sheet Income Statement Cash Common Assets Liabilities Revenues/Gains 100,000 Expenses/Losses Equity 100,000 Jan 1: Hired warehouse/marketing supervisor at salary of $2,000 per month (paid on 7th of each month after actual work month has elapsed) No journal entry since there was no actual transaction (no services performed by new employee yet)

  32. Balance Sheet Income Statement Cash Prepaid Rent Common Assets Liabilities Revenues/Gains 100,000 4,500 4,500 Expenses/Losses Equity 100,000 Jan 1: Prepaid $4,500 to landlord for 3 months rent on warehouse (Debit) Prepaid Rent $4,500 (Credit) Cash $4,500

  33. Balance Sheet Income Statement Cash Prepaid Rent Inventory Accts Paybl Common Assets Liabilities Revenues/Gains 100,000 4,500 55,000 4,500 55,000 Expenses/Losses Equity 100,000 Jan 10: Purchased $55,000 (10,000 units) of inventory on credit. 1% discount if paid within 10 days (Debit) Inventory $55,000 (Credit) Accounts Payable $55,000

  34. Balance Sheet Income Statement Cash Prepaid Rent Discount Inventory Accts Paybl Common Assets Liabilities Revenues/Gains 100,000 4,500 55,000 550 4,500 55,000 54,450 55,000 Expenses/Losses Equity 100,000 Jan 19: Paid $54,450 to inventory vendor (Debit) Accounts Payable $55,000 (Credit) Cash $54,450 (Credit) Gain on Discount $550

  35. Balance Sheet Income Statement Cash Prepaid Rent Sales Discount Inventory Accts Paybl Accts Recvbl COGS Common Assets Liabilities Revenues/Gains 100,000 4,500 55,000 26,000 550 4,500 55,000 54,450 55,000 26,000 11,000 Expenses/Losses 11,000 Equity 100,000 Jan 22: Sold 2,000 units of inventory on credit for $26,000. Collect 2% penalty if not paid in 15 days (Debit) Accounts Receivable $26,000 (Credit) Sales Revenue $26,000 (Debit) Cost of Goods Sold $11,000 (Credit) Inventory $11,000

  36. Balance Sheet Income Statement Cash Prepaid Rent Sales Discount Inventory Accts Paybl Accts Recvbl COGS Common Assets Liabilities Revenues/Gains 100,000 4,500 55,000 26,000 550 4,500 55,000 54,450 55,000 26,000 11,000 Expenses/Losses 11,000 Equity 100,000 Jan 30: We are done with active January entries. Now we need to passively adjust some accounts before we prepare the January balance sheet and income statement.

  37. Balance Sheet Income Statement Cash Prepaid Rent Sales Discount Inventory Accts Paybl Accts Recvbl COGS Common Rent Exp Assets Liabilities Revenues/Gains 100,000 4,500 55,000 26,000 550 4,500 1,500 55,000 54,450 55,000 26,000 11,000 Expenses/Losses 11,000 1,500 Equity 100,000 Jan 30: Passive adjustment to reflect prepaid rent that has been used up (Debit) Rent Expense $1,500 (Credit) Prepaid Rent $1,500

  38. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Assets Liabilities Revenues/Gains 100,000 4,500 55,000 2,000 26,000 550 4,500 1,500 55,000 54,450 55,000 26,000 11,000 Expenses/Losses 11,000 1,500 Equity 100,000 2,000 Jan 30: Passive adjustment to reflect the liability you now owe your employee for the work performed (Debit) Salary Expense $2,000 (Credit) Salary Payable $2,000

  39. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount 3,000 Inventory Accts Paybl 41,050 Accts Recvbl 44,000 0 COGS Sal Exp Common Rent Exp Assets Liabilities Revenues/Gains 100,000 4,500 55,000 2,000 26,000 550 4,500 1,500 55,000 54,450 55,000 26,000 11,000 Expenses/Losses 11,000 1,500 Equity 100,000 2,000 Jan 30: Now we can prepare the financial statements

  40. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 26,000 550 44,000 26,000 Expenses/Losses 11,000 1,500 Equity 100,000 2,000 Jan 30: Now we can prepare the financial statements

  41. Income Statement Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Sales 26,000 Assets Liabilities Revenues/Gains + Gain from Discount 550 41,050 3,000 0 2,000 26,000 550 = Total Revenues and Gains 26,550 - Cost of Goods Sold 11,000 - Rent Expense 1,500 2,000 - Salary Expense 44,000 26,000 = Net Income 12,050 Expenses/Losses 11,000 1,500 Equity 100,000 2,000 Jan 30: Now we can prepare the financial statements

  42. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Ret Earns Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 26,000 550 44,000 26,000 Expenses/Losses 11,000 1,500 Equity 100,000 2,000 Jan 30: Now we can prepare the financial statements After the income statement is prepared, we transfer Income Statement accounts into Retained Earnings to allow for balance sheet preparation

  43. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl 0 0 COGS Sal Exp Common Rent Exp Ret Earns Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 26,000 550 550 26,000 44,000 26,000 Expenses/Losses 11,000 1,500 Equity 100,000 26,550 2,000 Jan 30: Close Revenue Accounts into Retained Earnings (Debit) Sales $26,000 (Debit) Discount $550 (Credit) Retained Earnings 26,550

  44. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl 12,050 COGS Sal Exp 0 0 0 Common Rent Exp Ret Earns Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 0 0 44,000 26,000 Expenses/Losses 11,000 1,500 Equity 11,000 1,500 100,000 26,550 14,500 2,000 2,000 Jan 30: Close Expense Accounts into Retained Earnings (Debit) Retained Earnings $14,500 (Credit) Cost of Goods Sold $11,000 (Credit) Salary Expense $ 2,000 (Credit) Rent Expense $ 1,500

  45. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Ret Earns Total Assets = $114,050 Total Liabs + Equity = $114,050 Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 0 0 44,000 26,000 Expenses/Losses 0 0 Equity 100,000 12,050 0 Jan 30: Now the Balance Sheet is effectively already prepared

  46. Balance Sheet Income Statement Balance Sheet Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Ret Earns Assets Liabilities Assets Revenues/Gains Cash 41,050 Prep Rent 3,000 Inventory 44,000 Accts Rec 26,000 Total Assets 114,050 41,050 3,000 0 2,000 0 0 Liabilities + Owners’ Equity 44,000 26,000 Accts Pay 0 Salaries Pay 2,000 Common Stock 100,000 Retained Earns 12,050 Total Liabs + OE 114,050 Expenses/Losses 0 0 Equity 100,000 12,050 0 Jan 30: Now the Balance Sheet is effectively already prepared

  47. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Ret Earns Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 0 0 44,000 26,000 Expenses/Losses 0 0 Equity 100,000 12,050 0 February: Now we continue to build off of these accounts as the business continues February: Notice the Income Statement accounts are all “clean” to enable a new cumulation period

  48. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Rent Exp Ret Earns Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 0 0 39,000 39,000 44,000 26,000 16,500 Expenses/Losses 0 0 Equity 16,500 100,000 12,050 0 February 3: Sold 3,000 units of inventory for $39,000 cash (Debit) Cash $39,000 (Credit) Sales Revenue $39,000 (Debit) Cost of Goods Sold $16,500 (Credit) Inventory $16,500

  49. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Adv Exp Rent Exp Ret Earns Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 0 0 39,000 39,000 2,000 44,000 26,000 16,500 Expenses/Losses 0 0 Equity 16,500 100,000 12,050 0 2,000 February 7: Paid $2,000 cash for radio advertisements (Debit) Advertising Expense $2,000 (Credit) Cash $2,000

  50. Balance Sheet Income Statement Cash Prepaid Rent Sal Paybl Sales Discount Inventory Accts Paybl Accts Recvbl COGS Sal Exp Common Adv Exp Rent Exp Ret Earns Assets Liabilities Revenues/Gains 41,050 3,000 0 2,000 0 0 39,000 2,000 39,000 2,000 2,000 44,000 26,000 16,500 Expenses/Losses 0 0 Equity 16,500 100,000 12,050 0 2,000 February 7: Paid $2,000 salary to employee (Debit) Salary Payable $2,000 (Credit) Cash $2,000

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