Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 3

Reporting Operating Results on the Income Statement

3-2

Toni Braxton’s Situation

Toni Braxton had no way of knowing that she was headed for financial trouble since she had not

reviewed her personal income statement.

Revenues > Expenses = Net Income

Revenues < Expenses = Net Loss

3-3

Learning Objective 1

Describe common operating transactions and select appropriate

income statement account titles.

3-4

Revenues and Expenses

RevenuesHaircut Revenue 15,600$ Total Revenue 15,600

ExpensesSalaries and Wages Expense 8,000 Rent Expense 2,400 Utilities Expense 600 Advertising Expense 400 Insurance Expense 300 Total Expenses 11,700 Net Income 3,900$

SUPERCUTSIncome Statement

For the Month Ended September 30, 2008

Revenues are increases in a company’s resources created by

sales of goods or services to customers during the period.

Expenses are costs of business necessary to earn revenues.

Net income is the excess of revenues over expenses.

3-5

Time Period Assumption

RevenuesHaircut Revenue 15,600$ Total Revenue 15,600

ExpensesSalaries and Wages Expense 8,000 Rent Expense 2,400 Utilities Expense 600 Advertising Expense 400 Insurance Expense 300 Total Expenses 11,700 Net Income 3,900$

SUPERCUTSIncome Statement

For the Month Ended September 30, 2008The time period assumption assumes that the long life of a company

can be divided into shorter time periods, such as months, quarters, and

years.

3-6

Cash Basis Accounting

Cash basis accounting records revenues when cash

is received and expenses when cash is paid.

3-7

Cash Basis Accounting

The cash basis of accounting doesn’t measure financial

performance very well when transactions are conducted using

credit rather than cash.

3-8

Learning Objective 2

Explain and apply the revenue and

matching principles.

3-9

Accrual Basis Accounting

GAAPRecords revenues when they are

earned and expenses when they are incurred, regardless of the timing of

cash receipts or payments.

Accrual Basis Accounting

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Accrual Basis Accounting

Revenues are earned when goods or services are provided to customers at a determined

price and with reasonable assurance of collection.

Expenses are incurred when the economic benefits of an

item are used up in the current period, resulting in a decrease in the company’s resources.

3-11

Accrual Basis Accounting

The revenue principle is a concept that requires that

revenues be recorded when they are earned, rather than

when cash is received for them.

The matching principle is a concept that requires that

expenses be recorded in the period in which they are

incurred to generate revenue, rather than the period in which

they are paid.

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Company performs promised acts.

here(2)

here(1)

here(3)

Cash can be received . . .

(1) Cash is received in the same period as the promised acts are performed.

(2) Cash is received in a period before the promised acts are performed.

(3) Cash is received in a period after the promised acts are performed.

Revenue is recorded here.

Time

Timing of Reporting Revenue versus Cash Receipts

3-13

Company performs promised acts.

here(2)

here(1)

here(3)

Cash can be received . . .

(1) Cash is received in the same period as the promised acts are performed.

(2) Cash is received in a period before the promised acts are performed.

(3) Cash is received in a period after the promised acts are performed.

Revenue is recorded here.

Time

Timing of Reporting Revenue versus Cash Receipts

3-14

Company performs promised acts.

here(2)

here(1)

here(3)

Cash can be received . . .

(1) Cash is received in the same period as the promised acts are performed.

(2) Cash is received in a period before the promised acts are performed.

(3) Cash is received in a period after the promised acts are performed.

Revenue is recorded here.

Time

When cash is received before promised acts are performed, the company receiving the cash will report an increase in

cash and an increase in a liability, called unearned revenue, which represents the obligation to perform the acts in the

future.

Timing of Reporting Revenue versus Cash Receipts

3-15

Company performs promised acts.

here(2)

here(1)

here(3)

Cash can be received . . .

(1) Cash is received in the same period as the promised acts are performed.

(2) Cash is received in a period before the promised acts are performed.

(3) Cash is received in a period after the promised acts are performed.

Revenue is recorded here.

Time

When cash is received after promised acts are performed, the company performing the services will report an increase in

revenue and an increase in accounts receivable. Later, when the cash is received, the accounts receivable is reduced.

Timing of Reporting Revenue versus Cash Receipts

3-16

Quick Check

The following transactions occurred during the month of September for your Supercuts store. 1. Provided haircut services in September to customers for $15,000 cash.

2. Sold $300 of gift certificates in September.

3. Customers used $100 of gift certificates to pay for haircuts in September.

4. Provided $500 of hair styling services to employees of a local TV station, which is billed monthly.

5. The TV station paid $300 on its account.

How much revenue would you report for September?

3-17

Quick Check

The following transactions occurred during the month of September for your Supercuts store. 1. Provided haircut services in September to customers for $15,000 cash.

2. Sold $300 of gift certificates in September.

3. Customers used $100 of gift certificates to pay for haircuts in September.

4. Provided $500 of hair styling services to employees of a local TV station, which is billed monthly.

5. The TV station paid $300 on its account.

How much revenue would you report for September?(1) 15,000$ (3) 100 (4) 500

15,600$

(2) Is unearned revenue because services have not been provided at the time the gift certificate were sold.

(5) Is a payment on an accounts receivable.

3-18

Company incurs costs to generate revenue.

here(2)

here(1)

here(3)

Cash can be paid . . .

(1) Cash is paid at the same time as the cost is incurred to generate revenue.

(2) Cash is paid before the the cost is incurred to generate revenue.

(3) Cash is paid after the the cost is incurred to generate revenue.

Expense is recognized here.

Time

Timing of Reporting Expenses versus Cash Payments

3-19

Company incurs costs to generate revenue.

here(2)

here(1)

here(3)

Cash can be paid . . .

(1) Cash is paid at the same time as the cost is incurred to generate revenue.

(2) Cash is paid before the the cost is incurred to generate revenue.

(3) Cash is paid after the the cost is incurred to generate revenue.

Expense is recognized here.

Time

Timing of Reporting Expenses versus Cash Payments

3-20

Company incurs costs to generate revenue.

here(2)

here(1)

here(3)

Cash can be paid . . .

(1) Cash is paid at the same time as the cost is incurred to generate revenue.

(2) Cash is paid before the the cost is incurred to generate revenue.

(3) Cash is paid after the the cost is incurred to generate revenue.

Expense is recognized here.

Time

Timing of Reporting Expenses versus Cash Payments

Given the matching principle, the expense should be reported when the cost is incurred to earn revenue and not in the period

when the cash is paid.

3-21

Company incurs costs to generate revenue.

here(2)

here(1)

here(3)

Cash can be paid . . .

(1) Cash is paid at the same time as the cost is incurred to generate revenue.

(2) Cash is paid before the the cost is incurred to generate revenue.

(3) Cash is paid after the the cost is incurred to generate revenue.

Expense is recognized here.

Time

Timing of Reporting Expenses versus Cash Payments

Given the matching principle, the expense should be reported when the cost is incurred to earn revenue and not in the period

when the cash is paid.

3-22

Learning Objective 3

Analyze, record, and summarize the effects of operating transactions, using the accounting

equation, journal entries, and T-accounts.

3-23

The Expanded Debit/Credit Framework

= ++ Increases Decreases - - Decreases Increases + - Decreases Increases +

Assets Liabilities Stockholders' Equity

Debit Credit Debit Credit Debit Credit

Debit = Left Credit = Right

Asset accounts increaseincrease on the left or debitdebit side and decreasedecrease

on the right or creditcredit side.

Liability accounts increaseincrease on the right or creditcredit side and decreasedecrease

on the left or debitdebit side.

Stockholders’ equity accounts increaseincrease on the right or creditcredit side

and decreasedecrease on the left or debitdebit side.

Remember this from Chapter 2?

Let’s take a closer look at the accounts that affect Stockholders’ Equity.

3-24

Debit CreditDebit Credit

The Expanded Debit/Credit Framework

Debit CreditDebit Credit

3-25

Provided haircut services in September for $15,000 cash.

Debit CreditCash (+A) 15,000

Haircut Revenue (+R, +SE) 15,000

Accounts

Beg. Bal. 10,000 (a) 15,000

Cash- Beg. Bal.

15,000 (a)

Haircut Revenue

Assets = Liabilities + Stockholders' EquityCash +15,000 Haircut Revenue (R) +15,000

3-26

Debit CreditCash (+A) 300

Unearned Revenue (+L) 300

Accounts

Assets = Liabilities + Stockholders' EquityCash +300 Unearned Revenue +300

Sold $300 of gift certificates at the beginning of September.

- Beg. Bal.300 (b)

Uearned RevenueBeg. Bal. 10,000

(a) 15,000 (b) 300

Cash

3-27

Debit CreditAccounts Reveivable (+A) 500

Haircut Revenue (+R, +SE) 500

Accounts

Assets = Liabilities + Stockholders' EquityAccounts Receivable +500 Haircut Revenue (+R) +500

Provided $500 of haircut services to employees of a local TV station, which is billed every month.

Beg. Bal. - (c) 500

Accounts Reveivable- Beg. Bal.

15,000 (a)500 (c)

Haircut Revenue

3-28

Debit CreditCash (+A) 300

Accounts Reveivable (-A) 300

Accounts

Assets = Liabilities + Stockholders' EquityCash +300Accounts Reveivable -300

Supercuts received a $300 payment from the TV station.

Beg. Bal. - (c) 500 300 (d)

Accounts ReveivableBeg. Bal. 10,000

(a) 15,000 (b) 300 (d) 300

Cash

3-29

Debit CreditWages Expense (+E, -SE) 8,100

Cash (-A) 8,100

Accounts

Assets = Liabilities + Stockholders' EquityCash -8,100 Wages Expense (+E) -8,100

Supercuts paid stylists $8,100 for wages related to services they provided in September.

Beg. Bal. - (e) 8,100

Wages ExpenseBeg. Bal. 10,000

(a) 15,000 8,100 (e)(b) 300 (d) 300

Cash

3-30

Debit CreditPrepaid Rent (+A) 7,200

Cash (-A) 7,200

Accounts

Assets = Liabilities + Stockholders' EquityCash -7,200Prepaid Rent +7,200

On September 1, Supercuts paid $7,200 in advance for September, October, and November rent.

Beg. Bal. - (f) 7,200

Prepaid RentBeg. Bal. 10,000

(a) 15,000 8,100 (e)(b) 300 7,200 (f)(d) 300

Cash

3-31

Debit CreditPrepaid Insurance (+A) 3,600

Cash (-A) 3,600

Accounts

Assets = Liabilities + Stockholders' EquityCash -3,600Prepaid Insurance +3,600

On September 1, Supercuts paid $3,600 for an insurance policy that covers the period from September 1 until

August 31 of next year.

Beg. Bal. - (g) 3,600

Prepaid InsuranceBeg. Bal. 10,000

(a) 15,000 8,100 (e)(b) 300 7,200 (f)(d) 300 3,600 (g)

Cash

3-32

Debit CreditAdvertising Expense (+E, -SE) 400

Accounts Payable (+L) 400

Accounts

Assets = Liabilities + Stockholders' EquityAccounts Payable +400 Advertising Exp. (+E) -400

Supercuts received a bill for $400 for running a newspaper ad about special back-to-school prices. The

bill will be paid in October.

Beg. Bal. - (h) 400

Advertising Expense630 Beg. Bal.400 (h)

Accounts Payable

3-33

Debit CreditUtilities Expense (+E, -SE) 600

Cash (-A) 600

Accounts

Assets = Liabilities + Stockholders' EquityCash -600 Utilities Expense (+E) -600

Supercuts paid utility bills totaling $600 for services received and billed in September.

Beg. Bal. - (i) 600

Utilities ExpenseBeg. Bal. 10,000

(a) 15,000 8,100 (e)(b) 300 7,200 (f)(d) 300 3,600 (g)

600 (i)

Cash

3-34

T-Account Balances

Beg. Bal. 630 Supplies

Here are the asset account balances for your Supercuts store. (Beginning balances

came from Chapter 2.)Beg. Bal. 10,000

(a) 15,000 8,100 (e)(b) 300 7,200 (f)(d) 300 3,600 (g)

600 (i)End. Bal. 6,100

Cash

Beg. Bal. - (c) 500 300 (d)

End. Bal. 200

Accounts Reveivable

Beg. Bal. - (f) 7,200

End. Bal. 7,200

Prepaid Rent

Beg. Bal. - (g) 3,600

End. Bal. 2,400

Prepaid Insurance

Beg. Bal. 60,000 Equipment

3-35

T-Account Balances

630 Beg. Bal.400 (h)

1,030 End. Bal.

Accounts Payable

- Beg. Bal.300 (b)300 End. Bal.

Uearned Revenue

20,000 Beg. Bal.Notes Payable

Here are the liability account balances for your Supercuts store. (Beginning balances

came from Chapter 2.)

3-36

T-Account Balances

Here are the stockholders’ equity account balances for your

Supercuts store. (Beginning balances came from Chapter 2.)

50,000 Beg. Bal.Contributed Capital

- Beg. Bal.15,000 (a)

500 (c)15,500 End. Bal.

Haircut Revenue

Beg. Bal. - (e) 8,100

End. Bal. 8,100

Wages Expense

Beg. Bal. - (h) 400

End. Bal. 400

Advertising Expense

Beg. Bal. - (i) 600

End. Bal. 600

Utilities Expense

3-37

Learning Objective 4

Prepare an unadjusted trial

balance.

3-38

Unadjusted Trial Balance

Debit CreditCash 6,100$ Supplies 630 Accounts Receivable 200 Prepaid Rent 7,200 Prepaid Insurance 3,600 Equipment 60,000 Accounts Payable 1,030$ Unearned Revenues 300 Notes Payable 20,000 Contributed Capital 50,000 Haircut Revenue 15,500 Wages Expense 8,100 Utilities Expense 600 Advertising Expense 400 Total 86,830$ 86,830$

SUPERCUTSUnadjusted Trial BalanceAs of September 30, 2008

Amounts come from

ledger balances

Not a financial

statement

Debits = Credits

Listed in financial

statement order

3-39

Unadjusted Trial Balance

Some adjustments will have to be made at the end of the

accounting period to update the accounts.

For example, at the end of September, do we still have 3 months of Prepaid Rent left to

use? No, we used up 1/3 of the rent in September.

We will look more closely at adjustments in Chapter 4.

Debit CreditCash 6,100$ Supplies 630 Accounts Receivable 200 Prepaid Rent 7,200 Prepaid Insurance 3,600 Equipment 60,000 Accounts Payable 1,030$ Unearned Revenues 300 Notes Payable 20,000 Contributed Capital 50,000 Haircut Revenue 15,500 Wages Expense 8,100 Utilities Expense 600 Advertising Expense 400 Total 86,830$ 86,830$

SUPERCUTSUnadjusted Trial BalanceAs of September 30, 2008

3-40

Accounting for Revenues and Expenses

(2) Cash is received before the company

delivers goods/services.

dr. Cash

cr. Unearned Rev.

dr. Unearned Rev.

cr. Service Revenue$

(1) Cash is received in the same period the company delivers goods/services.

dr. Cash

cr. Service Revenue

$ (3) Cash is received after the company

delivers goods/services.

dr. Cash

cr. Accounts Rec.

dr. Accounts Rec.

cr. Service Revenue$

3-41

Accounting for Revenues and Expenses

(2) Cash is paid before the expense is

incurred.dr. Prepaid Expense

cr. Cash

dr. Business Expense

cr. Prepaid Expense$

(1) Cash is paid in the same period the

expense is incurred.

dr. Business Expense

cr. Cash

$(3) Cash is paid after

the expense is incurred.

dr. Accounts Payable

cr. Cash

dr. Business Expense

cr. Accounts Payable$

3-42

Learning Objective 5

Describe limitations of the income statement.

3-43

Income Statement Limitations

NI Cash

NI Value

NI Precise

3-44

Ethical Insights

Bernie Ebbers, CEO, WorldComRecorded expenses as assets

Sentenced to 25 years

Barry Minkow, CEO, ZZZZ BestRecorded fraudulent sales

Sentenced to 25 years

Martin Grass, CEO, Rite Aid Corp.Recorded rebates before earned

Sentenced to 8 years

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 3Supplement

Account Names

3-46

Chart of AccountsAccount Name Description

Sales Revenues Sales of products in the ordinary course of businessService Revenues Sales of services in the ordinary course of businessRental Revenues Amounts earned by renting out company propertyInterest Revenues Amounts earned on savings accounts and certificates of depositDividend Revenues Dividends earned from investing in other companiesOther Revenues Miscellaneous sources of revenues

Cost of Goods Sold Cost of products sold in the ordinary course of businessRepairs & Maintenance Cost of routine maintenance and upkeep of buildings/equipmentAdvertising Expense Cost of advertising services obtained during the periodDepreciation Expense Cost of plant and equipment used up during the periodInsurance Expense Cost of insurance coverage for the current periodSalaries & Wages Expense Cost of employees' salaries and wages for the periodRent Expense Cost of rent for the periodSupplies Expense Cost of supplies used up during the periodTransportation Expense Cost of freight to transport goods out to customersUtilities Expense Cost of power, light, heat, internet, and telephone for the periodAmortization Expense Cost of intangible assets used up or expired during the periodInterest Expense Interest charged on outstanding debts owedIncome Tax Expense Taxes charged on reported earnings

Revenues

Expenses

3-47

End of Chapter 3