Module 2 Accounting for Revenues and Expenses: Constructing the Income Statement and Statement of Stockholders Equity

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1 Module 2 Accounting for Revenues and s: Constructing the and Statement of Stockholders Equity Part 4 Learning Objectives 4. Explain revenue recognition, accrual accounting, and their effects on retained earnings. (p. 14) 5. Illustrate equity transactions and the statement of stockholders equity. (p. 19) Accrual Accounting for Revenues and s The income statement s ability to measure a company s periodic performance depends on the proper timing of revenues and expenses. Revenue should be recorded when it is earned, even if not yet received in cash. This is called revenue recognition. Similarly, expenses are recorded by matching them with revenues when incurred, even if not yet paid in cash, as assets are used or obligations created. Accrual accounting refers to this practice of recognizing revenues when earned and matching expenses when incurred. An important consequence of accrual accounting for revenues and expenses is that the balance sheet depicts the resources of the company (besides cash) and the obligations which the company must fulfill in the future. Accrual accounting is required under U.S. GAAP and IFRS because it is considered to be the most useful information for making business decisions and evaluating business performance. (That is not to say that information on cash flows is not important but it is conveyed by the statement of cash flows.) Walgreens net sales in 2011 were $72,184 million. Cost of goods sold (cost of sales) is an expense item in the income statements of manufacturing and merchandising companies. It represents the cost of products that are delivered to customers during the period. The difference between revenues (at selling prices) and cost of goods sold (at purchase price or manufacturing cost) is called gross profit. Gross profit for merchandisers and manufacturers is an important number as it represents the remaining income available to cover all of the company s overhead and other expenses (selling, general and administrative expenses, interest, and so on). Walgreens gross profit in 2011 is calculated as total net revenues less cost of sales, which equals $20,492 million ($72,184 million 2 $51,692 million). The principles of revenue and expense recognition are crucial to income statement reporting. To illustrate, assume a company purchases inventories for $100,000 cash, which it sells later in that same period for $150,000 cash. The company would record $150,000 in revenue when the inventory is delivered to the customer, because at that point, we say that it has been earned. Also assume that the company pays $20,000 cash for sales employee wages during the period. The income statement is designed to tell how effective the company was at generating more resources than it used, and it would appear as follows: LO4 Explain revenue recognition, accrual accounting, and their effects on retained earnings. 14

2 Revenues $150,000 Cost of goods sold ,000 Gross profit ,000 Wages expense ,000 Net income (earnings).... $ 30,000 In this illustration, there is a correspondence between each of the revenues/expenses and a cash inflow/outflow. Net income was $30,000 and the increase in cash was $30,000. However, that need not be the case under accrual accounting. Suppose that the company sells its product on credit (also denoted as on account) rather than for cash. Does the seller still report sales revenue? The answer is yes. Under GAAP, revenues are reported when a company has earned those sales. Earned means that the company has done everything required under the sales agreement no major contingencies remain and cash is realized or realizable. The seller reports an accounts receivable asset on its balance sheet, and revenue can be recognized without cash collection. Credit sales mean that companies can report substantial sales revenue and assets without receiving cash. When such receivables are ultimately collected, no further revenue is recorded because it was recorded earlier when the revenue recognition criteria were met. The collection of a receivable merely involves the decrease of one asset (accounts receivable) and the increase of another asset (cash), with no resulting increase in net assets. Next consider a different situation. Assume that the company sells gift cards to customers for $9,500. Should the $9,500 received in cash be recognized as revenue? No. Even though the gift cards were sold and cash was collected, the revenue has not been earned. The revenue from gift cards is recognized when the product or service is provided. For example, revenue can be recognized when a customer purchases an item of merchandise using the gift card for payment. Hence, the $9,500 is then recorded as an increase in cash and an increase in unearned revenue, a liability, with no resulting increase in net assets. The proper timing of revenue recognition suggests that the expenses incurred in earning that revenue be recognized in the same fiscal period. Thus, if merchandise inventory is purchased in one period and sold in another, the cost of the merchandise should be retained in the accounting records until the items are sold. It would not be proper to recognize expense when the inventory was purchased or the cash was paid. Accurate income determination requires the proper timing of revenue and expense recognition, and the exchange of cash is not the essential ingredient. We have already seen that when a company incurs a cost to acquire a resource that produces benefits in the future (for example, merchandise inventory for future sale), it recognizes an asset. That asset represents costs that are waiting to be recognized as expenses in the future, based on the matching principle. When inventory is delivered to a customer, we recognize that the asset no longer belongs to the selling company. The inventory asset is decreased, and cost of goods sold is recognized. The same principle applies when employees earn wages for work in one period, but are paid in the next period. Wages expense must be recognized when the cost is incurred, regardless of when they are paid. If the company in the illustration doesn t pay its employees until the following reporting period, it recognizes a wages payable liability of $20,000 and, because this decreases net assets, it would recognize a wage expense of the same amount. When wages are paid in the next reporting period, both cash and the wages payable liability are decreased. No expense is reported when the wages are paid, because the expense is recognized when the employees worked to generate sales in the prior period. Accrual accounting principles are crucial for reporting the income statement revenues and expenses in the proper period, and these revenues and expenses provide a more complete view of the inflows and outflows of cash for the firm. Was an outflow of cash supposed to produce benefits in the current period or in a future period? Was an inflow of cash the result of past operations or current operations? The accrual accounting model uses the balance sheet and income statement to answer such questions and to enable users of financial statements to make more timely assessments of the firm s economic performance. However, accrual accounting s timeliness requires management to estimate future events in determining the amount of expenses incurred and revenue earned. The precise amount of cash to FYI Purchase of inventories on credit or on account means that the buyer does not pay the seller at the time of purchase. The buyer reports a liability (accounts payable) on its balance sheet that is later removed when payment is made. The seller reports an asset (accounts receivable) on its balance sheet until it is removed when the buyer pays. FYI Sales on credit will not always be collected. The potential for uncollectable accounts introduces additional risk to the firm. FYI accounting recognizes revenues only when received in cash and expenses only when paid in cash. This approach is not acceptable under GAAP. 15

3 be received or disbursed cannot be known until a later date. In the case of wages, the amount of the accrual is known with certainty. In other cases (e.g., incentive bonuses), it may not and thus require an estimate. Net income for the period is added to the company s retained earnings, which, in turn, is part of stockholders equity. The linkage between the income statement and the beginning and endofperiod balance sheets, which we called articulation in Module 1, is achieved by tying net income to retained earnings because net income is, by definition, the change in retained earnings resulting from business activities during an accounting period. This link is highlighted by the red arrow at the top of the financial statement effects template (FSET). 4 There are typically other adjustments to retained earnings. The most common adjustment is for dividend payments to stockholders. Exhibit 2.3 provides the annual adjustments to retained earnings for Walgreens. EXHIBIT 2.3 Walgreens Reconciliation Walgreen Co. and Subsidiaries Year Ended August 31, 2011 ($ millions) earnings, August 31, $16,848 Add: Net earnings... 2,714 19,562 Less: dividends declared earnings, August 31, $18,877 Analyzing and Recording Transactions for the Earlier, we introduced the financial statement effects template as a tool to illustrate the effects of transactions on the balance sheet. In this section, we show how this template is used to analyze transactions that may affect the current period s income statement. To do so, we extend our illustration of Natural Beauty Supply (NBS) to reflect the following events in 2013: (5) Nov. 2 NBS paid $670 to advertise in the local newspaper for November. (6) Nov. 18 NBS paid $13,300 cash to its suppliers in partial payment for the earlier delivery of inventory. (7) Nov. During the month of November, NBS sold products to retail customers. The customers paid $7,000 cash for products that had cost NBS $4,000. (8) Nov. During the month of November, sales to wholesale customers totaled $2,400 for merchandise that had cost $1,700. Instead of paying cash, wholesale customers are required to pay for the merchandise within ten working days. (9) Nov. NBS employed a salesperson who earned $1,400 for the month of November and was paid that amount in cash. (10) Nov. 24 NBS received an order from a wholesale customer to deliver products in December. The agreed price of the products to be delivered is $700 and the cost is $450. (11) Nov. 25 NBS introduced holiday gift certificates, which entitle the recipient to a onehour consultation on the use of NBS s products. $300 of gift certificates were sold for cash, but none were redeemed before the end of November. (12) Nov. 30 NBS received $1,450 in partial payment from customers billed in (8). 4 In the FSET, we show that each transaction that affects the income statement also impacts retained earnings. This approach is useful for analyzing the effect of the transaction on both the income statement and balance sheet. However, the impact of net income on retained earnings is recorded only once each accounting period, after all of the revenues and expenses have been recorded. This recording procedure is explained later in this module and in Module 3. 16

4 (13) Nov. 30 NBS repaid the loan and interest in (2). (14) Nov. 30 NBS paid $1,680 for a twelvemonth fire insurance policy. Coverage begins on December 1. (15) Nov. 30 NBS paid $1,500 to the landlord for November rent. In the fifth transaction, Natural Beauty Supply gave cash in return for advertising for the month of November. This payment does not create a benefit for future periods, so it does not create an asset. Nor does the payment discharge an existing obligation. Therefore, it decreases NBS s net assets (assets minus liabilities). The purpose of this decrease in net assets is to generate revenues for the company, so it is matched by an expense in the income statement. We begin by entering the decrease in cash and an increase in expenses. (The minus sign in front of expenses insures that the accounting equation still holds.) Recording the expense allows the income statement to keep track of the flows of assets and liabilities that result from the company s operations. Transaction Asset 1 Noncash = Liabilities 1 Contrib. 1 Earned Revenues s = Net Income (5) Pay $670 cash for November advertising = 1670 Advertising = However, the FSET goes further than recording the accounting entry. It also depicts the effects of the expense on net income and of net income on retained earnings. So, the complete FSET description of transaction (5) is as follows. The FSET uses color to differentiate between the accounting entry (in blue) and the resulting effect on income and retained earnings (in black). (5) Pay $670 cash for November advertising = Advertising = 2670 In the sixth transaction, Natural Beauty Supply made a partial payment of $13,300 in cash to the suppliers who delivered inventory on November 1. This transaction decreases cash by $13,300 and decreases the accounts payable liability by $13,300. The income statement is not affected by this payment. The cost of merchandise is reflected in the income statement when the merchandise is sold, not when it is paid for (as we will see shortly). (6) Pay $13,300 cash in partial payment to suppliers from transaction ,300 = 213,300 Accounts = Payable In transaction seven, Natural Beauty Supply sold products to customers who paid $7,000 in cash. This cash receipt is an increase in net assets resulting from NBS s revenuegenerating activities, so it results in revenue being recognized in the income statement. As in transaction 5, the FSET also depicts the impact of these sales on net income and on the retained earnings balance. (7a) Sell $7,000 of products for cash. 17,000 = 17,000 17,000 Sales = 17,000 Revenue At the same time, NBS must recognize that these sales transactions involved an exchange, and cash was received while inventory costing $4,000 was delivered. Transaction (7b) recognizes that NBS no longer has this inventory and that this decrease in net assets produces an expense called cost of goods sold. In this way, the income statement portrays the increases in net assets (revenues) and the decreases in net assets (expenses like cost of goods sold and advertising) from the company s operating activities. (Again, the minus sign in front of all expenses insures that the accounting equation remains balanced.) 17

5 Transaction Asset 1 Noncash = Liabilities 1 Contrib. 1 Earned Revenues s = Net Income (7b) Record $4,000 for the cost of merchandise sold in transaction 7a. 24,000 Inventory = 24,000 14,000 Cost of = 24,000 Goods Sold The eighth transaction is very similar to the previous one, except that Natural Beauty Supply s customers will pay for the products ten days after they were delivered. Should NBS recognize revenue on these sales? The products have been delivered, so the revenue has been earned. 5 Therefore, NBS should recognize that it has a new asset accounts receivable equal to $2,400, and that it has earned revenue in the same amount. As above, NBS would also record cost of goods sold to recognize the cost of inventory delivered to the customers. (8a) Sell $2,400 of products on account. 12,400 Accounts Receivable = 12,400 12,400 Sales Revenue = 12,400 (8b) Record $1,700 for the cost of merchandise sold in transaction 8a. 21,700 Inventory = 1,700 11,700 Cost of Goods Sold = 1,700 The ninth entry records wage expense. In this case, wages were paid in cash. is decreased by $1,400, and this decrease in net assets results in a recognition of wages expense in the income statement (with resulting decreases in net income and retained earnings). (9) Record $1,400 in wages to employees. 21,400 = 1,400 11,400 Wages = 1,400 Transaction ten involves a customer order for products to be delivered in December. This transaction is an example of an executory contract, which does not require a journal entry. NBS has not earned revenue, because it has not yet delivered the products. (10) Receive customer order. Memorandum entry for customer order In transaction eleven, Natural Beauty Supply sold gift certificates for $300 cash, but none were redeemed. In this case, NBS has received cash, but revenue cannot be recognized because it has not yet been earned. Rather, NBS has accepted an obligation to provide services in the future when the gift certificates are redeemed. This obligation is recognized as a liability titled unearned revenue. (11) Sell gift certificates for $300 cash = 1300 Unearned Revenue = In transaction twelve, NBS received $1,450 cash as partial payment from customers billed in transaction eight. increases by $1,450 and accounts receivable decreases by $1,450. Recall that revenues are recorded when earned (transaction 8), not when cash is received. (12) Receive $1,450 cash as partial payment from customers billed in transaction 8. 11,450 21,450 Accounts Receivable = = 5 For the time being, we assume that the receivables collectability is assured. 18

6 In transaction thirteen on November 30, Natural Beauty Supply paid back the family member who had loaned money to the business. The cash payment was the agreedupon $5,050 ($5,000 principal and $50 interest). The repayment of the principal does not change the net assets of NBS; cash goes down by $5,000 and the note payable liability goes down an equal amount. However, the payment of $50 interest does cause the net assets to decrease, and this net asset decrease creates an interest expense in the income statement. Transaction Asset 1 Noncash = Liabilities 1 Contrib. 1 Earned Revenues s = Net Income (13) Pay interest of $50 and repay principal of $5, ,050 = 25,000 Notes Payable Interest = 250 In the fourteenth transaction, NBS paid an annual insurance premium of $1,680 for coverage beginning December 1. NBS will receive the benefits of the insurance coverage in the future, so insurance expense will be recognized in those future periods. At this time, a noncash asset titled prepaid insurance is increased by $1,680, and cash is decreased by the same amount. (14) Pay $1,680 for oneyear insurance policy. 21,680 11,680 Prepaid Insurance = = In the last transaction of the month of November, Natural Beauty Supply paid $1,500 cash to the landlord for November s rent. This $1,500 reduction of net assets is balanced by rent expense in the income statement. (15) Pay $1,500 rent for November. 21,500 = 21,500 11,500 Rent = 21,500 We can summarize the revenue and expense entries of these transactions to prepare an income statement for Natural Beauty Supply for the month ended November 30, NATURAL BEAUTY SUPPLY, Inc. For Month Ended November 30, 2013 Sales revenue... $ 9,400 Cost of goods sold... 5,700 Gross profit... 3,700 Wages expense... 1,400 Rent expense.... 1,500 Advertising expense Operating income Interest expense Net income.... $ 80 Reporting on Equity Analyzing and Recording Equity Transactions Earlier we recorded the effect of issuing common stock on the balance sheet of Natural Beauty Supply. To complete our illustration, we illustrate one final equity transaction a dividend payment. LO5 Illustrate equity transactions and the statement of stockholders equity. 19

7 (16) Nov. 30 Natural Beauty Supply paid $50 cash dividend to its shareholders. To record the dividend payment, we decrease cash and decrease retained earnings. Transaction Asset 1 Noncash = Liabilities 1 Contrib. 1 Earned Revenues s = Net Income (16) Pay $50 cash dividend to shareholders. 50 = 50 = No revenue or income is recorded from a stock issuance. Similarly, no expense is recorded from a dividend. This is always the case. Companies cannot report revenues and expenses from capital transactions (transactions with stockholders relating to their investment in the company). The FSET entries can be accumulated by account to determine the ending balances for assets, liabilities and equity. Natural Beauty Supply s balance sheet for November 30, 2013, appears in Exhibit 2.4. The balance in retained earnings is $30 (net income of $80 less the cash dividend of $50). EXHIBIT 2.4 Natural Beauty Supply s Natural Beauty Supply, Inc. November 30, $ 8,100 Accounts receivable Inventory... 11,300 Prepaid insurance... 1,680 Security deposit... 2,000 Total current assets... 24,030 Total assets... $24,030 Liabilities Accounts payable... $ 3,700 Unearned revenue Total current liabilities... 4,000 Equity Common stock... 20,000 earnings Total equity... 20,030 Total liabilities and equity... $24,030 Statement of Stockholders Equity The statement of stockholders equity is a reconciliation of the beginning and ending balances of selected stockholders equity accounts. The statement of stockholders equity for Natural Beauty Supply for the month of November is in Exhibit 2.5. This statement highlights three main changes to Natural Beauty Supply s equity during November. 1. Natural Beauty raised $20,000 in equity capital during the month. 2. Natural Beauty Supply earned net income of $80. That is, its business activities increased the company s net assets by $80 during the month. 3. Natural Beauty Supply declared a $50 cash dividend. 20

8 EXHIBIT 2.5 Natural Beauty Supply s Statement of Stockholders Equity Natural Beauty Supply, Inc. Statement of Stockholders Equity For Month Ended November 30, 2013 Contributed Earned Total Equity Balance, November 1, $ 0 $ 0 $ 0 Common stock issued... 20,000 20,000 Net income dividends... (50) (50) Balance, November 30, $20,000 $30 $20,030 Summary Explain revenue recognition, accrual accounting, and their effects on retained earnings. (p. 14) Revenues must be recognized only when they have been earned and realized (or realizable). s incurred to generate revenues should be recognized in the same period as the revenues. Illustrate equity transactions and the statement of stockholders equity. (p. 19) The statement of stockholders equity reports transactions resulting in changes in equity accounts during the accounting period. Transactions between the company and its owners, such as dividend payments, are not reported in the income statement. LO4 LO5 21