Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 1 Principles of Accounting Principles of Accounting Fulbright Economics Teaching Program Ho Chi Minh City, Vietnam Academic Year: 2005-2006 INCOME STATEMENT Lecture Notes 3a Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 2 Principles of Accounting by Nguyen Bao Linh Measuring the Business Performance Net Income (NI) = Revenues (R) – Expenses (E)  Revenues: the price of products, merchandise, and services supplied by a firm to its customers during a certain period  Expenses: the cost of products, merchandise, and services used by a firm during a certain period by Nguyen Bao Linh Methods of Recognition  The accrual basic recognizes the impacts of transactions on the financial statements when revenues and expenses occur regardless whether cash changes hands  The cash basis only records transactions when cash is disbursed or received Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 3 Principles of Accounting by Nguyen Bao Linh Accounting Period  To periodically provide information to users, the firm’s operating process is allotted into relatively equal period, called accounting period  The length of an accounting period may be a month, a quarter, or a year. One- year length is called a fiscal year by Nguyen Bao Linh Accounting Period  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 Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 4 Principles of Accounting by Nguyen Bao Linh Permanent and Temporary Accounts  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  A permanent account is not closed at the end of period; its ending balance becomes the beginning one for the next period by Nguyen Bao Linh Permanent and Temporary Accounts Assets (A) Liabilities (L) Owners’ Equity (OE): Capital Withdrawals Revenues (R) Expenses (E) Permanent Accounts Temporary Accounts Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 5 Principles of Accounting by Nguyen Bao Linh Matching Rule  Revenues are recognized in an accounting period during which the firm provides products, merchandise, and services to customers  Expenses that are recognized in an accounting period must been used up during that period to generate the period revenues by Nguyen Bao Linh Going-concern Rule  Firms are assumed to be continuously and indefinitely operating unless there is evidence on bankruptcy or stopping business  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 Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 6 Principles of Accounting by Nguyen Bao Linh Revenue Recognition  Revenues are recognized when goods and/or services are delivered to customers regardless whether collections have been made  To secure the matching rule, revenues are also recorded by adjusting accounts at the end of the accounting period Revenue Cash Receivables by Nguyen Bao Linh Expense Recognition  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  Expenses are also recorded by adjusting accounts at the end of the accounting period ExpenseCash Payables Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 7 Principles of Accounting by Nguyen Bao Linh Adjustments to the Accounts  Adjustments are made through the adjusting entries at the end of each period  The purpose of adjustments is to fully account revenues and expenses for an accurate profit measurement  Only revenues and expenses involved in more than one period are adjusted  An adjusting entry is always related to a permanent and a temporary account. Hence, an adjusting entry affects both balance sheet and income statement by Nguyen Bao Linh 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 Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 8 Principles of Accounting Deferred revenue: Collections from customers have been received but should be allocated over many periods by Nguyen Bao Linh Adjustment to Revenues  See the example in the previous lecture notes  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  Suppose, by January 31, the firm has provided services costing $400  Adjusting entry (a) Advances from Customers 400 Revenues 400 Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 9 Principles of Accounting Deferred expense: Disbursements have been made but should be allocated over many periods by Nguyen Bao Linh Prepaid Expense  See the example, on January 1, the firm advances a rental of $3,000 for 6 month use.  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  Similarly, with prepaid insurance on Jan 5, the adjusting entry will be (c) Insurance Expense 100 Prepaid Insurance 100 Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 10 Principles of Accounting by Nguyen Bao Linh Cost of Supplies  Suppose that an ending-period inventory reveals a stationery balance of $200  Hence, the portion of stationery used during period is $800 - $200 = $600  Adjusting entry (d) Stationery Expense 600 Stationery 600 by Nguyen Bao Linh Depreciation Expense  Depreciation expense is the cost of long-term or fixed assets  Depreciation expense is calculated based on the value of the asset and its estimated usable life  There are many methods to account depreciation; the most commonly used is the straight line depreciation method  The going concern rule is applied in accounting depreciation [...]... balances for the next periods; an accounting cycle has been closed, and a new one starts by Nguyen Bao Linh Nguyen Bao Linh 15 Fulbright Economics Teaching Program 2005-2006 Principles of Accounting Lecture Notes 3 Income Statement References Financial accounting – Clyde P Stickney; Roman L Weil Accounting – Charles T Horngren; Walter T Harrison; Linda Smith Bamber Principles of accounting – Belverd E Needles,... Teaching Program 2005-2006 Principles of Accounting Lecture Notes 3 Income Statement Depreciation Expense Suppose that the office equipment is depreciated under the straight-line method and has a usable life of 5 years (60 months) The depreciation expense is $6,000 ÷ 60 = $100 for each month Adjusting entry (e) Depreciation Expense of Equipment 100 Accumulate Depreciation of Equipment 100 by Nguyen... balance them to calculate profits by Nguyen Bao Linh Nguyen Bao Linh 13 Principles of Accounting Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Uses of Work Sheet Preparing financial statements Closing temporary accounts Recording adjusting entries by Nguyen Bao Linh Closing Temporary Accounts Temporary accounts must be closed at the end of the period to be prepared... accounted in advance Nguyen Bao Linh 11 Fulbright Economics Teaching Program 2005-2006 Principles of Accounting Lecture Notes 3 Income Statement Wages & Salaries Expenses Salaries are paid on Friday after two-week working, costing $1,000 Average salaries expense is $100 per day Salaries payments were made on the 12th and 26th of January How about the next payment? January Mon Tue Wed Thu Fri Sat Sun 1 2 3... 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 An adjusting entry (f) is necessary Salaries Expense Salaries Payable 300 300 by Nguyen Bao Linh Nguyen Bao Linh 12 Principles of Accounting Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Work sheet Transaction... recording in the next period Temporary accounts include – Revenues – Expenses – Withdrawals Closing can be directly done or through the Income Summary Account by Nguyen Bao Linh Nguyen Bao Linh 14 Principles of Accounting Fulbright Economics Teaching Program 2005-2006 Lecture Notes 3 Income Statement Closing Income Summary Expense XXX XXX / Withdrawals X X XXX XX / / XXXXX / Revenue XXXXX XXXXX / / Capital . 2005-2006 Lecture Notes 3 Income Statement Nguyen Bao Linh 1 Principles of Accounting Principles of Accounting Fulbright Economics Teaching Program Ho Chi Minh. Bao Linh 10 Principles of Accounting by Nguyen Bao Linh Cost of Supplies  Suppose that an ending-period inventory reveals a stationery balance of $200 