MEASURING BUSINESS

INCOME
MEASURING BUSINESS INCOME
• Net Income is an increase in owner’s equity that results form the
profitable operation of a business during an accounting period..
• Net income also may be defined as revenue minus expenses.
• Revenue is the price of goods sold and services rendered to customer
during the period
• Expenses are the cost of the goods ad services used up in he process
of earning revenue.
MEASURING BUSINESS INCOME
• When to record Revenues? The realization principle indicates that
revenue should be recorded in the accounting records when it is
earned—that is, when goods are sold or services are rendered to
customers.

• The matching principle indicates that expense should be offset

against revenues on a basis of cause and effect.
• The expense should be recorded in the period in which the related
goods or service is consumed in the process of earning revenue.
Expenditure Benefiting More Than One
Accounting Period.
• Not all transactions can be so precisely divided by accounting periods.
• The purchase of a building, furniture and fixtures , machinery etc.
provides benefit over all the years in which such an asset is used. No
one can determine in advance exactly how many years of service will
be received, the accountant must estimate what portion of the cost of
the asset is applicable to the current year.
•
• For some expenditures, such as those for advertising or employee
training programs, it is not possible to estimate objectively the
number of accounting periods over which revenue is likely to be
produced. In such case generally accepted accounting principles
(GAAP) require that the expenditure be charged immediately to
expense.
• This treatment is based upon the accounting principle of objectivity
and the concept of conservatism (applying the accounting treatment
which results in the lowest (most conservative) estimate of net
income for the current period.
MEASURING BUISNES INCOME
• Rules of debit and credit in recording revenue and expenses.
• Revenues increases owner’s equity, therefore revenue is recorded by
a credit.

• Expenses decrease owner’s equity, therefor expenses are recorded by

debits
• Investment and Withdrawals by the Owner:
• The owner of a business does not technically receive a salary, instead
he can withdraw cash, other asset and pay his personal bills out of
company’s funds.
• For personal use Drawings reduce asset and owner’s equity of the
business but they are not expenses.
• Expenses are incurred for the purpose of generating revenue, and
withdrawals from owners do not have this purpose.
• Recording Revenue and Expense Transactions of Robert Real Estate Company.
• Oct. 1 Paid $ 360 for publication of newspaper advertising
describing various houses offered for sale.
• Oct. 6. Earned and collected a commission of $ 2250 by selling a residence
previously listed by a client.
• Oct. 16. Newspaper advertising was purchased at a price of $ 70, payment
to be made with 30 days.
• Oct 20. A commission of $ 8390 was earned by selling a clients residence.
The sale agreement provided that the commission would be received in 60
days
• Oct. 25. Roberts withdrew $ 2800 for personal use.

• Oct. 30. Robert found that he did not all of the $ 2800 withdrawn on
Oct. 25, and he re-deposited $ 1000 of this amount in the company’s
Bank account.
• Oct. 31. Paid salaries of $ 7100 to employees for services rendered
during October.
• Oct. 31. A telephone bill for October accounting to $ 144 was
received. Payment was required by November 10.
• First Journal Entry to record the October transactions. (Example)
Date Accounts Title and Explanations LP Debit $ Credit $
2015 Advertising Expense 360
Oct. 1 Cash 360
Paid for news paper advertising
• Ledger (T account):
• Make ledger accounts of the following from above example;

• Cash Accounts Payable

• Advertising expense Salaries expense
• Telephone expense James Robert; Drawing
• Sales commission earned
Measuring Business Income
• Adjusting entries: Many transactions affect the revenue or expenses
of two or more accounting periods. A business may purchase
equipment that will last for many years, insurance policies that covers
12 months. Each of these assets is gradually used up that is becomes
expense.
• Accounts allocates the cost of these assets to expense over a span of
several accounting periods through adjusting entries.
• Adjusting entries are made at the end of each accounting period.
• Adjusting entry to record Depreciation expense.
• Depreciation expense: it refers to the systematic allocation of the cost
of a long lived asset (such as equipment or building) to expense over
the useful life useful life.
• Depreciation is recorded by an entry debiting Depreciation expense
and crediting the contra-asset account, Accumulated depreciation
• Journal Entry to record depreciation expense of the Building for the
month of October; Cost: $ 36000, Estimated Life: 20 years.
• General Journal
Date Accounts Title and Explanations LP Debit $ Credit $
2015 Depreciation Expense 150
Oct. 31 Accumulated Depreciation-Building 150
To record depreciation expense of the building for the
period . ($ 36000+240= $ 150 a month.
• ROBERT REAL ESTATE COMPANY
• Partial Balance Sheet
October 31, 2015
Building at (cost) $ 36000
Less: Accumulated Depreciation 150 $ 35850
• Journal Entry to record depreciation expense of the office equipment
for the month of October; Cost: $ 5400, Estimated Life: 10 years.
• General Journal
Date Accounts Title and Explanations LP Debit $ Credit $
2015 Depreciation Expense 45
Oct. 31 Accumulated Depreciation-Office equipment 45
To record depreciation expense of the building for the
period . ($ 5400+120) a month.
• ROBERT REAL ESTATE COMPANY
• Partial Balance Sheet
October 31, 2015
Office equipment at (cost) $ 5400
Less: Accumulated Depreciation 45 $ 5355
• The Adjusted Trial Balance: After all the necessary adjusting entries
have been journalized and posted an adjusted trial balance is
prepared to prove that the ledger is still in balance.
• It also provides a complete listing of the accounts balances to be used
in preparing the financial statements.
Income Statement, Statement of Owner’s
Equity and Balance Sheet

• An income statement show the revenue and expenses of business

during a specified accounting period.
• Expenses are offset (matched) against revenue to measure net
income for the period.
• Net income is then listed in the statement of owner’s equity.
• Withdrawals by owner are shown as a deduction. Thus the statement
of owner’s equity shoes the increases and decreases in owner’s
equity from one balance sheet date to the next.
• ROBERT REAL ESTATE COMPANY
• Income Statement
For the month ended October 31, 2015
Revenue:
Sales Commission Earned $ 10640
Expenses:
Advertising expenses $ 630
Office salaries expense 7100
Telephone expense 144
Depreciation expense-Building 150
Depreciation expense-Office equipment 45 8069
Net Income 2571
• ROBERT REAL ESTATE COMPANY
• Statement of Owner’s Equity
For the month ended October 31, 2015
James Robert’s Capital Sept. 30, $ 180000
Add: Net Income for October 2571
Additional investment by owner 1000
183571
Less: Withdrawals by owner 2800
James Roberts capital, October 31, 2015 180771
• ROBERT REAL ESTATE COMPANY
• Balance Sheet
October 31, 2015
Assets: Liabilities & Owner’s Equity
Cash 15400 Liabilities:
Accounts Receivable 17890 Accounts payables $ 23814
Land 130000 Owner’s Equity:
Building 36000 James Robert’s Capital 180771
Less: Accumulated Depreciation 150 35850
Office equipment 5400
Less: Accumulated Depreciation 45 5355
204585 204585
• Closing entries: serves two basic purpose. The first is to return the
balances of the temporary owner’s equity accounts (revenue,
expenses and drawing accounts to zero so that these accounts may be
used to measure the activities of the next accounting period.
• The second purpose of closing entries is to update the balance of the
owner’s capital account.
Closing the temporary accounts
• Four closing entries generally are needed:
• 1. Close the revenue account in the Income summary account.

• 2. Close the expense account in the income summary account

• 3. Close the balance of Income summary account (representing net

income or net loss) into the owner’s capital account.

• 4. Close the drawings account into the owner’s capital account

Closing entries for Revenue Accounts
• Journal Entry to close the Sales commission earned.
• General Journal

Date Accounts Title and Explanations LP Debit $ Credit $

2015 Sales Commission Earned 10640
Oct. 31 Income Summary
To clos the Sales Commission Earned Account 10640
Closing entries for Expense Accounts,
through compound journal entry

• General Journal

Date Accounts Title and Explanations LP Debit $ Credit $

2015 Income Summary 8069
Oct. 31 Advertising Expense 8069
Salaries Expense 7100
Telephone Expense 144
Depreciation Expense-Building 150
Depreciation Expense-Equipment 45
To close the expenses accounts.
Closing the Income Summary Account
• Journal Entry to close the Sales commission earned.
• General Journal

Date Accounts Title and Explanations LP Debit $ Credit $

2015 Income Summary 2571
Oct. 31 James Robert’s Capital 2571
To close the Income Summary account for October by
transferring the net income to the owner’s capital account.
Closing entries for Drawing Account
• Journal Entry to close the Sales commission earned.
• General Journal

Date Accounts Title and Explanations LP Debit $ Credit $

2015 James Robert’s Capital 2800
Oct. 31 Drawings 2800
To close the owner’s account
Summary of the closing process
• 1. Close the various revenue accounts by transferring their balances
into the Income Summary account.
• 2. Close the various expense account by transferring their balance
into the Income Summary account into the owner’s capital account
• 3. Close the Income Summary account by transferring its balance into
the owner’s capital account.
• 4. Close the owner’s drawing account into the owner’s capital account
(the balance of the owner’s capital in the ledger will now be the same
as the amount of owner’s equity, appearing in the balance sheet)
After closing trial balance

• ROBERT REAL ESTATE COMPANY

• After-Closing Trial Balance
October 31, 2015
Cash $ 15400
Accounts Receivable 17890
Land 130000
Building 36000
Accumulated Depreciation-Building $ 150
Office equipment 5480
Less: Accumulated Depreciation-Office Equipment 45
Accounts Payable 23814
James Robert’s, capital 180771
__________________
$ 294780 $ 204780
Sequence of procedures in the accounting
cycle
• 1. Journalize transactions
• 2. Post to ledger account
• 3. Prepare a trial balance
• 4. Make end of period adjustments
• 5. Prepare an adjusted trial balance
• 6. Prepare financial statements
• 7. Journalize and post closing entries
• 8. Prepare an after closing trial balance
The accrual Basis and the Cash Basis
accounting

• Under accrual accounting revenue is recognized when it is earned and

expenses as are recognized in the period in which they contribute to
generation of revenue.
• Under the cash basis revenue is recognized when cash is received and
expenses are recognized when cash payments are made.
• The accrual basis gives a better measurement of profitability than
does the cash basis
Key Terms of The Chapter
• The Accounting period: The span of time covered by an income
statement. One year is a standard accounting period, but many
companies also prepare monthly and quarterly financial statement.

• Adjusting entries: required at the end of the period to update the

accounts before financial statements are prepared.
• Adjusting entries serve to apportion transactions properly between
the accounting periods affected and to record any revenue earned or
expenses incurred which have not been recorded prior to the end of
the period.
Key Terms of The Chapter

• Conservatism: The traditional accounting practice of resolving

uncertainty by choosing the solution which leads to the lower (more
conservative) amount of income being recognized in the current
accounting period.
• This concept is designed to avoid overstatement of financial strength
or earnings.
Key Terms of The Chapter
• Fiscal year: Any 12-month accounting period adapted by a business.
• Income summary account: The summary account in the ledger t
which revenue and expenses accounts are closed at the end of the
period.
• The balance (credit for a net income, debit balance for a net loss) is
transferred to the owner’s capital account.
• Matching principle: The revenue earned during an accounting period
is matched (offset) wit expenses incurred in generating this revenue.
Key Terms of The Chapter

• Realization principle: The generally accepted accosting principle that

determines when revenue should be record in the accounting records.
• Revenue is realized when services are rendered to customers or when
goods sold are delivered to customers.
• Statement of owner’s equity: A financial statement summarizing the
increases and decreases in owner’s equity during an accounting
period.
Key Terms of The Chapter

• Time period principle: To provide the users of financial statements

timely information, net income is measured for relatively short
accounting periods of equal length.
• The period of time covered by an income statement is termed the
company’s accounting period.