Chapter Three

Measuring Income & Completion of the Accounting Cycle

3.1. What is net Income?

In chapter one, we started that a basic objective of every business is to earn a
profit, or net income. Why? The answer lies in the very definition of net income:
an increase in owners’ equity resulting from the profitable operation of the
business. The opposite of net income, a decrease in owners’ equity resulting
from unprofitable operation of the business, is termed as a net loss.
Notice that net income does not consist of cash or any other specific asset.
Rather, net income is a computation of the overall effects of many business
transactions upon owners’ equity. The increase in owners’ equity resulting
from profitable operations usually is accompanied by an increase in total
assets, though not necessarily an increase in cash. In some cases, however, an
increase in owners’ equity is accompanied by a decrease in total liabilities.
Our point is that net income represents an increase in owners’ equity, and
has no direct relationship to the types or amounts of assets on hand.
Consequently even a business operating at a profit may run short of cash and
become insolvent.

Assets = Liabilities + Stockholders’ Equity

Capital Stock
Amount invested in the
Corporation by its owners’
╬
Retained Earnings
Earnings retained in the
business – net income over
the life of the business less
any net losses and dividends

In the balance sheet, the changes in owners’ equity resulting from profitable or
unprofitable operations are reflected in the balance of the stockholders equity
account, Retained Earnings. The assets of the business organization appear
only in the assets section of the balance sheet.
Retained Earnings
Retained Earnings account appears in the stockholders’ equity section of the
balance sheet. Earning net income causes the balance in the retained Earnings
account to increase. However, many corporations follow a policy of distributing
to their stockholders some of the resources generated by profitable operations.
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Distributions of this nature are termed dividends, and they reduce both total
assets and stockholders’ equity. The reduction in stockholders equity is
reflected by decreasing the balance of the Retained Earnings account.
The balance of the Retained Earnings account represents the total net income of
the corporation over the entire lifetime of the business, less all amounts which
have been distributed to the stockholders as dividends. In short, retained
earnings represent the earnings that have been retained by the corporation to
finance growth. Some of the largest corporations have become large by
consistently retaining in the business most of the resources generated by
profitable operations.
The Income Statement: A Preview
An Income Statement is a one-page financial statement which summarizes the
profitability of the business entity over a specified period of time. In this
statement, net income is determined by comparing for the time period: (1) the
sales price of the goods sold and services rendered by the business, with (2) the
cost to the business of the goods and services used up in business operations.
The technical accounting terms for these components of net income are
revenue and expenses. Therefore, accountants say that net income is equal to
revenue minus expenses.
When we measure the net income earned by a business we are measuring its
economic performance – its success or failure as a business entity. Investors,
managers, and major creditors are anxious to see the latest available income
statement and thereby to judge how well the company is doing.
Let us now explore the meaning of the accounting terms revenue and
expenses.
Revenue
Revenue is the price of goods sold and services rendered during a given
accounting period. Earning revenue causes owners’ equity to increase. When a
business renders services or sells merchandise to its customers, it usually
receives cash or acquires an accounts receivable from the customer. The inflow
of cash and receivables from customers increases the total assets of the
company; on the other side of the accounting equation, liabilities do not change,
but owners’ equity increases to match the increase in total assets. Thus revenue
is the gross increase in owners’ equity resulting from operation of the
business.
Various terms are used to describe different types of revenue, for example, the
revenue earned by a real estate broker might be called Sales Commissions
Earned, or alternatively, Commissions Revenue. In the professional practice of
lawyers, physicians, dentists, and CPAs, the revenue is called Fees Earned. A
business which sales merchandise rather than services will use the terms Sales
to describe the revenue earned. Another type of revenue is Interest Earned,
which means the amount received as interest on notes receivable, bank loans,
government bonds, or other securities.

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Expenses
Expenses are the costs of the goods sold and services used up in the
process of earning revenue. Examples include the cost of employees’ salaries,
advertising, rent, utilities, and the gradual wearing out (depreciation) of such
assets as buildings, automobiles, and office equipment. All these costs are
necessary to attract and serve customers and thereby earn revenue. Expenses
are often called the “the costs of doing business,” that is, the cost of the various
activities necessary to carry on a business.
An expense always causes a decrease in owners’ equity. The related changes
in accounting equation can be either (1) a decrease in assets, or (2) an increase
in liabilities. An expense reduces assets if payment occurs at the time that the
expense is incurred. If the expense will not be paid until later, as, for example,
the purchase of advertising services on account, the recording of the expense
will be accompanied by an increase in liabilities.
Debit and Credit Rules for Revenue and Expenses
We have stressed that revenue increases owners’ equity and that expenses
decrease owners’ equity. The debit and credit rules for recording revenue and
expenses in the ledger accounts are a natural extension of the rules for
recording changes in owners’ equity. The rules previously stated for recording
increases and decreases in owners’ equity were as follows:
• Increases in owners’ equity are recorded by credits.
• Decreases in owners’ equity are recorded by debits.

This rule is now extended to cover revenue and expense accounts:

• Revenue increases owners’ equity; therefore revenue is recorded by

a credit.
• Expenses decrease owners’ equity; therefore expenses are recorded
by debits.
Ledger Accounts for Revenue and Expenses
During the course of an accounting period, a great many revenue and expense
transactions occur in the average business. To classify and summarize these
numerous transactions, a separate ledger account is maintained for each major
type of revenue and expense. For example, almost every business maintains
accounts for Advertising Expense, Telephone Expenses, and Salaries Expenses.
At the end of the period, all the advertising expenses appear as debits in the
advertising Expense account. The debit balance of these account represents the
total advertising expense of the period and is listed as one of the expense items
in the income statement.
Dividends
A dividend is a distribution of assets (usually cash) by a corporation to its
stockholders. In some respects, dividends are similar to expenses – they reduce

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both the assets and the owners’ equity in the business. However, dividends are
not expenses and they are not deducted from revenue in the income
statement. The reason that dividends are not viewed as an expense is that
these payments do not serve to generate revenue. Rather, they are a
distribution of profits to the owners of the business.
Since the declaration of a dividend reduces the stockholders equity, the
dividend could be recorded by debiting the Retained Earnings account.
However, a clearer record is created if a separate Dividends account is
debited for all amounts distributed as dividends to stockholders. The
disposition of Dividends account when financial statements are prepared will be
illustrated later in this chapter.

The debit credit rules for revenue, expenses, and dividends are summarized
below:

Owners’ Equity

Decreases recorded by Debits Increases recorded by Credits

Expenses decrease owners’ equity Revenue increases owners’ equity
Expenses are recorded by debits Revenue is recorded by Credit
Dividends reduce owners’ equity
Dividends are recorded by debits

Recording Revenue and Expenses Transaction: An Illustration

The organization of Greenhill Real Estate during October has already been
described in Chapter 1 and 2. The illustration is now continued for November,
during which month the company earns commissions by selling several
residences for its clients. Bear in mind that the company does not own any
residential property; it merely acts as a broker or agent for clients wishing to
sell their houses. A commission of 6% of the selling price of the house is
charged for this service. During November the company not only earns
commissions but incurs a number of expenses.
The transactions of Greenhill Real Estate for November are as follows:
Nov. 1 The corporation pays $360 for publication of newspaper advertising
describing various houses offered for sale..
Nov. 6 Greenhill Real Estate earns and collects a commission of $3,734 by
selling a listed property.
Nov. 16 Greenhill purchases radio advertising for November at a price of $270,
payment to be made within 30 days.
Nov. 20 The Corporation earns a commission of $8,390 by selling a clients
residence. The sales agreement provides that commission be
collected in 60 days.

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Nov. 30 Greenhill Real Estate pays salaries of $7,100 to employees for services
rendered during November.
Nov. 30 The corporation receives November telephone bill amounting to $144.
Payment is required by December. 10.
Nov. 30 The corporation declares and pays a dividend of 25 cents per share to
the owners of the 8,000 shares of capital Stock – total $2,000 (As
explained earlier, a dividend is not an expense).
The Journal
The journal entries to record the November transactions are shown below as
they appear in the General Journal.

GENERAL JOURNAL Page No. 2

Date Account Title and Explanation LP Debit Credit
20 _
Nov. 1 Advertising Expense 70 360
Cash 1 360
Paid for newspaper advertising.

6 Cash 1 3,734
Sales Commission Earned 60 3,734
Earned and collected commission by selling
residence for clients.

16 Advertising Expense 70 270

Accounts Payable 32 270
Purchase radio advertising; payable in 30 days.
20 Accounts Receivable 4 8,390
Sales Commission Earned 60 8,390
Earned commission by selling residence for client;
commission to be received in 60 days..
30 Salaries Expense 72 7,100
Cash 1 7,100
Paid salaries for November.
30 Telephone Expense 74 144
Accounts Payable 32 144
To record liability for November telephone.
30 Dividends 52 2,000
Cash 1 2,000
Paid dividend to stockholders (8,000 shares at 25
per shares).

The column headings at the top of the illustrated journal page (Date, Account
Titles and Explanation, LP, Debit, and Credit) are seldom used in practice.
They are included here as an instructional guide but will be omitted from some
of the latter illustrations of journal entries.

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The Ledger

The ledger of Greenhill Real Estate after the November transactions have been
posted is now illustrated. To conserve space in this illustration, several ledger
accounts appear on a single page; in actual practice, however, each account
occupies a separate page in the ledger.

Cash Account No. 1

Date Explanation Ref Debit Credit Balance
20 __
Oct. 1 1 80,000 80,000
3 1 52,000 28,000
5 1 6,000 22,000
25 1 600 22,600
30 1 6,800 15,800
Nov. 1 2 360 15,440
6 2 3,734 19,174
30 2 7,100 12,074
30 2 2,000 10,074

Accounts Receivable Account No. 4

Date Explanation Ref Debit Credit Balance
20 __
Oct. 20 1 1,800 1,800
25 1 600 1,200
Nov. 20 2 8,390 9,590

Land Account No. 20

Date Explanation Ref Debit Credit Balance
20 __
Oct. 3 1 52,000 52,000

Building Account No. 22

Date Explanation Ref Debit Credit Balance
20 __
Oct. 5 1 36,000 36,000

Office Equipment Account No. 25

Date Explanation Ref Debit Credit Balance
20 __
Oct. 17 1 13,800 13,800
20 1 1,800 12,000

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 Notes Payable Account No. 30
Date Explanation Ref Debit Credit Balance
20 __
Oct. 5 1 30,000 30,000

Accounts Payable Account No. 32

Date Explanation Ref Debit Credit Balance
20 __
Oct. 17 1 13,800 13,800
30 1 6,800 7,000
Nov. 16 2 270 7,270
30 2 144 7414

Capital Stock Account No. 50

Date Explanation Ref Debit Credit Balance
20 __
Oct. 1 1 80,000 80,000

Retained Earnings Account No. 51

Date Explanation Ref Debit Credit Balance
20 __ -0-

Dividends Account No. 52

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 2,000 2,000

Sales Commission Earned Account No. 60

Date Explanation Ref Debit Credit Balance
20 __
Nov. 6 2 3,734 7,734
20 2 8,390 12,124

Advertising Expense Account No. 50

Date Explanation Ref Debit Credit Balance
20 __
Nov. 1 2 360 360
16 2 270 630

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 Salaries Expense Account No. 72
Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 7,100 7,100

Telephone Expense Account No. 74

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 144 144

The accounts in this illustration are listed in financial statement order – that is,
balance sheet accounts first (assets, liabilities, and owners’ equity), followed by
income statement accounts. The sequence of accounts within the balance sheet
categories was discussed in chapter 2. Within the categories of revenue and
expense, accounts may be listed in any order.
The Trial Balance
A trial balance prepared from Greenhill’s ledger accounts is shown below:

GREENHILL REAL ESTATE

Trial Balance
November 30, 20___

Cash ……………………………………… $10,074

Accounts Receivable ………………. 9,590
Land …………………………………….. 52,000
Building ……………….………………. 36,000
Office Equipment ……….…..……… 12,000
Notes Payable …………………………. $ 30,000
Accounts Payable …………………… 7,414
Capital Stock …..……………………. 80,000
Retained Earnings …………………... -0-
Dividends --------------------------------- 2,000
Sales Commission Earned ………… 12,124
Advertising Expense ………………… 630
Salaries Expense ……………………... 7,100
Telephone Expense …………………. 144
$129,538 $129,538

This trial balance proves the equality of the debit and credit entries in the
company’s ledger. Notice that the trial balance contains income statement
accounts as well as a balance sheet accounts. The balance of $0 in the Retained
Earnings account is a highly unusual situation, existing only because this is
the first month of business operations.

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Adjusting Entries the Next Step in the Accounting Cycle

Many transactions affect the revenue or expenses of two or more accounting

periods. For example, a business may purchase equipment that will last for
many years, insurance policies that cover 12 months, or enough office supplies
that last for several months. Each of these assets is generally used up – that is,
it becomes expense. How are the costs of these assets allocated to expense over
a span of several accounting periods? The answer is by making adjusting
entries at the end of each accounting period.
There are several different types of adjusting entries; in fact, a business may
make a dozen or more adjusting entries each period. In this chapter, we
introduce the concept of end-of-period adjustments with the two most
common types of adjusting entries: those made to recognize depreciation
expense and income tax expense. Other types of adjusting entries will be
discussed briefly towards the end of the chapter.

The Concept of Depreciation

Depreciable assets are physical objects which retain their size and shape, but
which usually wear out or become obsolete. They are not physically
consumed, as are assets such as office supplies, but nonetheless their economic
usefulness is “used up” over time.
Each period a portion of depreciable asset’s usefulness expires. Therefore, a
corresponding portion of its cost is recognized as depreciation expense.

What is depreciation? In accounting, the term depreciation means the

systematic allocation of the costs of an asset to expense over the
accounting periods making up the asset’s useful life. The process is illustrated
below:

Balane Sheet
Assets:
Cost of a Depreciable Assets Building
Equipment, Etc.

As the asset
is “used up”

Income Statement
Revenues:
Expenses:
Depreciation

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Depreciation is not an attempt to record changes in the asset’s market value. In
the short run, the market value of some depreciable assets ay even increase,
but the process of depreciation continues any way. The rationale for
depreciation lies in the matching principle. Our goal is to offset a reasonable
portion of the asset’s cost against revenue in each period of the asset’s useful
life.
Depreciation expense occurs continuously over the life of the asset, but there
are no daily “depreciation transactions.” In effect, depreciation expense is
paid in advance when the asset is originally purchased. Therefore, adjusting
entries are needed at the end of each accounting period to transfer an
appropriate amount of the asset’s cost to depreciation expense.
Depreciation is only an estimate: the “apportion amount” of depreciation
expense is only an estimate. After all, we cannot look at a building or a piece
of equipment and determine precisely how much of its economic usefulness has
expired during the current period.
The most widely used means of estimating periodic depreciation expense is the
straight-line method. Under the straight line approach, an equal portion of
the asset’s cost is allocated to depreciation expense in every period of the asset’s
estimated useful life. The formula for computing depreciation expense by the
straight line method is:

Depreciation expense (per period) = Cost of the asset

Estimated useful life

The use of an estimated useful life is the major reason why depreciation
expense is only an estimate. In most cases, management does not know in
advance exactly how long the asset will remain in use.
In their financial statements, most companies determine depreciation expense
by the straight line method. In income tax returns, however, they often use
different methods.

Recording depreciation Expense: An Illustration

Greenhill Real Estate owns two categories of depreciable assets: (1) building,
and (2) office equipment. Because these categories of assets have different
useful lives, depreciation must be computed separately for each category.
Management elects to compute depreciation expense by the straight line
method.

Depreciation on the Building: Greenhill purchased its building for $36,000.

Because the building was old, management estimates that it has a remaining
useful life of only 20 years. Thus, Greenhill will recognize annual depreciation
expense equal to 1/20 of the building’s cost, or $1,800 ($36,000 cost ÷ 20 years
estimated useful life). On a monthly basis, the depreciation amounts to $150
(($36,000 cost ÷ 240 months).

10
The adjusting entry to record depreciation on this building for the month of
November appears below:

GENERAL JOURNAL Page No. 2

Date Account Title and Explanation LP Debit Credit
20 __
Nov. 30 Depreciation Expense- Building 76 360
Accumulated Depreciation- Building 23 360
To record depreciation for November. Cost of
$36,000 ÷ 240 months = $150 a month.

The Depreciation Expense account will appear in Greenhill’s income statement

for November, along with the other expenses for the month. The Accumulated
Depreciation account will appear in the balance sheet as a deduction from the
balance of the building account, as shown below:

GREENHILL REAL ESTATE

Partial Balance Sheet
November 30, 20___
Assets
Cash …………………………………………………………… $10,074
Accounts Receivable ……………………………………. 9,590
Land ………………………………………………………….. 52,000
Building ……………….…………………. 36,000
Less: Accumulated depreciation..... 150 30,850

The end result of crediting the Accumulated Depreciation: Building account is

much the same as if the credit has been made to the Building account: that is,
the net amount shown on the balance sheet for the building is reduced from
$36,000 to $35,850. Although the credit side of a depreciation entry could be
made directly to the asset account, it is customary and more efficient to record
such credits in a separate account entitled Accumulated Depreciation. The
original cost of the asset and the total amount of depreciation recorded over the
years can more easily be determined from the ledger when separate accounts
are maintained for the asset and for the accumulated depreciation.

Accumulated Depreciation: Building is an example of a contra-asset account,

because it has a credit balance and is offset against an asset account (Building)
to produce the proper balance sheet amount for the asset.

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Depreciation on the Office Equipment: Greenhill also must record
depreciation on its office equipment. This equipment cost $12,000, and
management estimates that it will remain in service for about 10 years. Thus,
the monthly depreciation expense amounts to $100 ($12,000 cost ÷ 120
months). The adjusting entry to recognize this monthly expense is:

GENERAL JOURNAL Page No. 2

Date Account Title and Explanation LP Debit Credit
20 __
Nov. 30 Depreciation Expense- Office Equipment 78 100
Accumulated Depreciation- Office Equipment 26 100
To record depreciation for November. Cost of
$12,000 ÷ 120 months = $100 a month.

Similar adjusting entries to recognize depreciation expense on the buildings and

office equipment will be made each month throughout the assets’ useful lives.
Once the assets have become fully “depreciated,” that is, their total cost has
been recognized as depreciation expense, the recognition of depreciation will
stop. (We do not recognize depreciation on these assets in October, because
Greenhill had not yet begun its regular business operations. Depreciation
begins when assets are placed in use for their intended business purpose.)

Depreciation is a “Noncash” Expense: we have made the point that net

income does not represent an inflow of cash or any other asset. Rather, it is a
computation of the overall effect of certain business transactions upon owners’
equity. The computation and recognition of depreciation expense illustrate this
point.
As depreciable assets “expire,” owners’ equity declines, but there is no
corresponding cash outlay in the current period. For this reason, depreciation
often is called a “noncash expense.” Often represents the largest difference
between net income and the cash flows (receipts and payments) resulting from
business operations.

Accounting for Corporate Income taxes

Profitable businesses that are organized as corporations must file income tax
returns and pay income taxes equal to a percentage of their taxable incomes.
These taxes represent an expense of the business organization. Income taxes
usually are paid in four quarterly installments. But, if we are to properly
“match” income taxes with the related revenue, income taxes expense should
be recognized (or accrued) in the periods in which the taxable income is
earned. This is accomplished by an adjusting entry at the end of each
accounting period.

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Computing Income Tax expense: income tax expense is determined by
applying the current tax rate to the taxpayer’s taxable income. This
relationship is summarized in the following page.

Taxable Income Tax Rate Income taxes

(determined according X (set by law) = expense
to tax regulations)

Taxable income is not the same as “net Income.” Taxable income is computed
in conformity with income tax regulations, rather than generally accepted
accounting principles (GAAP). The rules for computing taxable income normally
change somewhat from one year to the next. In a very simple case, taxable
income may be equal to revenue less all expenses other than income tax
expense. We will use this simplifying assumption in computing and recording
Greenhill Real Estate’s income tax expense.
The tax rate is the percentage of taxable income that must be paid as income
taxes. These rates may change from year to year, and also vary depending upon
the amount of taxable income. But for purposes of illustration, we assume a
corporate income tax rate of 40% to include the effects of both federal and state
income taxes.
Under the assumptions stated above, Greenhill’s income tax expense for
November amounts to $1,600, determined as follows:

Sales Commission Earned …………………………………………………. $12,124

Less: Deductible Expenses:*
Advertising ………………………………………………… $ 630
Salaries ……………………………………………………… 7,100
Telephone …………………………………………………… 144
Depreciation – Building ………………………………… 150
Depreciation – Office Equipment …………………… 100
Total Deductible Expenses ………………………………………………… 8,124
Taxable Income ……………………………………………………………….. $ 4,000
Income taxes expense ($4,000 taxable income x 40%) ………….. $ 1,600

In an income statement, income tax expense often is termed “Provision for

Income Taxes.”

Recording Income Tax Expense: Income taxes expense accrues each month,
but it is not payable until dates which are specified by income tax authorities.
Therefore, monthly income tax expense is recorded by an adjusting entry, such
as the one shown on the following page.

13
 GENERAL JOURNAL Page No. 2
Date Account Title and Explanation LP Debit Credit
20 __
Nov. 30 Income Taxes Expense 80 1,600
Income Taxes payable 35 1,600
To record income taxes expense for the
Month of November: $4,000x40%=$1600

The amount of income taxes expense will appear in Greenhill’s November

income statement; income taxes payable is a short-term liability that will
appear in the balance sheet.
Income taxes expense differs from other business expenses in several ways.
First, only businesses organized as corporations incur income taxes
expense. Unincorporated businesses, such as sole proprietorships and
partnerships, do not pay income taxes. The taxable incomes earned by
unincorporated businesses are taxable directly to the owners of these
businesses, not to the business entities themselves.
Also, paying income taxes does not help produce revenue. For this reason,
income taxes expense usually is shown separately from other expenses in the
income statement – often following a subtotal called Income (or loss) before
income taxes.

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 account balances to be used in preparing
the financial statements. The following adjusted trial balance differs from the
trial balance shown before because it includes accounts for depreciation
expense, income taxes expense, accumulated depreciation and income taxes
payable.

Once an adjusted trial balance has been prepared, the process of recording
changes in financial position for this accounting period is complete.
Financial statements are prepared directly from the adjusted trial balance.
Every account in the adjusted trial balance contains its end-of-the-period
balance, with the exception of the Retained Earnings account. During the
accounting period, transactions affecting retained earnings were not recorded
directly in the Retained Earnings account. Rather, these transactions were
recorded in the various revenue, expense, and dividends accounts. Therefore,
the amount of retained earnings shown in the adjusted trial balance is the
retained earnings at the beginning of the accounting period. These will not
cause a problem; as we prepare a “set” of financial statements, the amount of
retained earnings at the end of the period will become apparent.

14
Let us now look at the process of preparing a set of financial statements
directly from the amounts listed in the adjusted trial balance.

GREENHILL REAL ESTATE

Adjusted Trial Balance
November 30, 20___
Cash …………………………………………. $10,074
Accounts Receivable …………………… 9,590
Land …………………………………………. 52,000
Building ……………….…………………… 36,000
Accumulated Depreciation – Building ……………… $ 150
Office Equipment ……….…..………….. 12,000
Accumulated Depreciation – Office Equipment…. 100
Notes Payable ……………………………………………… 30,000
Accounts Payable ………………………………………… 7,414
Income Taxes Payable ………………………………….. 1,600
Capital Stock …..…………………………………………. 80,000
Retained Earnings ………………….......................... -0-
Dividends …………………………………… 2,000
Sales Commission Earned ……………………………. 12,124
Advertising Expense ……………………… 630
Salaries Expense ……………………........ 7,100
Telephone Expense ……………………… 144
Depreciation Expense – Building …….. 150
Depreciation Expense – Office Equipment 100
Income taxes expense …………………. 1,600
$131,388 $131,388

Preparing a Set of Financial Statements

Now that Greenhill real Estate has been operating for a month, managers and
outside parties will want to know more about the company than just its
financial position. They will want to know the results of operation – whether
the month’s activities have been profitable or unprofitable. To provide the
additional information, we will prepare a more complete set of financial
statements, consisting of an income statement, a statement of retained
earnings, and a balance sheet. These statements are illustrated on the follow.
The Income Statement
The revenue and expenses shown in the income statement are taken directly
from the company’s adjusted trial balance. The income statement of Greenhill
Real Estate shows that revenue earned in November exceeded the expenses of
the month, thus producing a net income of $2,600. Bear in mind, however, that
our measurement of net income is not absolutely accurate or precise,
because of the assumptions and estimates in the accounting process.

15
Alternative titles for the income statement include Earnings Statement,
Statement of Operations, and Profit and Loss Account. However, Income
Statement is by far the most popular term for this important financial
statement. In summary, we can say that an income statement is used to
summarize the Operating results of a business by matching revenue earned
during a given time period with the expenses incurred in obtaining that
revenue.

The Statement of Retained Earnings

Retained earnings is that portion of the stockholders’ equity created by

earning net income and retaining the related resources in the business. The
Statement of Retained Earnings summarizes the increases and decreases in
retained earnings resulting from the business operations of the accounting
period. Increases in retained earnings result from earnings net income;
decreases result from net losses and from the declaration of dividends.

Retained Earnings Retained Earnings

at the beginning + Net Income – Dividends = at the end
of the period of the period

The amount of retained earnings at the beginning of the period is shown at the
top of the statement. Next the net income for the period is added (or net loss
subtracted), and any dividends declared during the period are deducted. This
short computation determines the amount of retained earnings at the end of the
accounting period. The ending retained earnings ($400 in our example) appears
at the bottom of the statement of retained earnings and also in the company’s
end-of-the-period balance sheet.
The ending retained earnings of one accounting period becomes the beginning
amount for the next. Thus, the statement of retained earnings prepared for
Greenhill next month (December) will show beginning retained earnings of
$400.

The Balance Sheet

The balance sheet lists the amount of the company’s assets, liabilities, and
owners’ equity at the end of the accounting period. The balances of the asset
and liability accounts are taken directly from the adjusted trial balance. The
amount of retained earnings at the end of the period, $400, was determined in
the statement of retained earnings.
Previous illustrations of balance sheets have been arranged in account form –
that is, with the assets on the left and liabilities and owners’ equity on the right.
The illustration on the preceding page is arranged in reported form, with the
liabilities and owners’ equity sections listed below rather than to the right of the
asset section. Both the account form and the reported form of balance sheet are
widely used.

16
 GREENHILL REAL ESTATE
Income Statement
November 30, 20___
Revenue:
Sales Commission Earned ………………………………………………… $12,124
Expenses:
Advertising ………………………………………………… $ 630
Salaries ……………………………………………………… 7,100
Telephone ……………………………………………………. 144
Depreciation – Building …………………………………. 150
Depreciation – Office Equipment ……………………… 100
Total Deductible Expenses ………………………………………………… 8,124
Income before Income Tax…………………………..……………………… $ 4,000
Income taxes expense …………………………………………..………….. $ 1,600
Net Income …………………………..…………………………………..…. $ 2,400

GREENHILL REAL ESTATE

Income Statement
November 30, 20___
Retained Earnings, Oct. 31, 20__ ………………………………………. $ -0-
Net Income for November ………………………………………………. 2,400
Subtotal …………………………………………………………………….. 2,400
Less: Dividends ………………………………………………………………. 2,000
Retained Earnings, Nov. 31, 20__ …………………………………… $ 400

GREENHILL REAL ESTATE

Balance Sheet
November 30, 20___
Assets
Cash ………………………………………………………………………… $10,074
Accounts Receivable ………………………………………………….. 9,590
Land ………………………………………………………………………… 52,000
Building ……………….……………………………………… 36,000
Less: Accumulated Depreciation – Building ……… 150 35,850
Office Equipment ……….…..…………………………….. 12,000
Less: Accumulated Depreciation–Office Equipment…. 100 11,900
Total Assets ………………………………………………………………. $119,414
Liabilities & Stockholders’ Equity
Liabilities:
Notes Payable ……………………………………………………………. 30,000
Accounts Payable ………………………………………………………. 7,414
Income Taxes Payable ………………………………………………... 1,600
Total liabilities ………………………………………………………… $ 39,014
Stockholders’ Equity:
Capital Stock …..…………………………………………. 80,000
Retained Earnings ………………….......................... 400
Total Stockholders’ Equity ………………………………………… 80,400
Total liabilities & Stockholders’ Equity …………………………. $119,414

17
Relationship among the Financial Statements

A set of financial statements becomes easier to understand if we recognize that

the income statement, statement of retained earnings, and balance sheet all are
related to one another. These relationships are emphasized by the arrows in
the right hand margin of our illustration on page 17.
The balance sheet prepared at the end of the preceding period and the one
prepared at the end of the current period both include the amount of retained
earnings at the respective balance sheet dates. The statement of retained
earnings summarizes the factors (net income and dividends) which have
caused the amount of the retained earnings to change between these two
balance sheets. The income statement explains in greater detail the changes
in retained earnings resulting from profitable operation of the business. Thus,
the income statement and retained earnings statement provide informative
links between successive balance sheets.

Closing the Temporary Accounts

As previously stated, revenue increases retained earnings, and expenses and

dividends decrease retained earnings. If the only financial statement that we
needed was a balance sheet, these changes in retained earnings could be
recorded directly in the retained earnings account. However, owners,
managers, investors, and others need to know amounts of specific revenue and
expenses, and the amount of net income earned in the period. Therefore, we
maintain separate ledger accounts to measure each type of revenue and
expense, and the dividends distributed.
These revenue, expense, and dividends accounts are called temporary
accounts, or nominal accounts, because they accumulate the transactions of
only one accounting period. At the end of the accounting period, the changes in
retained earnings accumulated in these temporary accounts are transferred into
the retained earnings account. This process serves two purposes. First, it
updates the balance of the retained earnings account for changes in retained
earnings occurring during the accounting period. Second, it returns the
balances of the temporary accounts to zero, so that they are ready for
measuring the revenue, expenses, and dividends of the next accounting period.

The retained earnings account and other balance sheet accounts are called
permanent or real accounts, because their balances continue to exist beyond
the current accounting period. The process of transferring the balances of the
temporary accounts into the retained earnings account is called closing the
accounts. The journal entries made for the purpose of closing the temporary
accounts are called closing entries.
Revenue and expense accounts are closed at the end of the accounting period
by transferring their balances to a summary account called Income Summary.
When the credit balances of the revenue accounts and the debit balances of the
expense accounts have been transferred into one summary account, the
balance of this Income Summary will be the net income or net loss for the

18
period. If the revenue (credit balances) exceeds the expenses (debit balances),
the Income Summary account will have a credit balance representing net
income. Conversely, if expenses exceed revenue, the Income Summary will have
a debit balance representing net loss. This is consistent with the rule that
increases in owners’ equity are recorded by credits and decreases are recorded
by debits.
It is common practice to close the accounts only once a year, but for
illustration, we will demonstrate the closing of the accounts of Greenhill Real
Estate at November 30 after one month operation.

Closing Entries for Revenue Accounts

Revenue accounts have credit balances. Therefore, closing a revenue account

means transferring its credit balance to the Income Summary account. This
transfer is accomplished by a journal entry debiting the revenue account in an
amount equal to its credit balance, with an offsetting credit to the Income
Summary account. The debit portion of this closing entry returns the balance of
the revenue account to zero; the credit portion transfers the former balance of
the revenue account into the Income Summary account.
The only revenue account of Greenhill Real Estate is Sales Commissions
Earned, which had a credit balance of $12,124 at November 30. The closing
entry is as follows:

GENERAL JOURNAL Page No. 3

Date Account Title and Explanation LP Debit Credit
20 __
Nov. 30 Sales Commission Earned 60 12,124
Income Summary 53 12,124
To close the Sales Commission Earned account

After the closing entry has been posted, the two accounts affected will appear
as follows.

Sales Commission Earned Account No. 60

Date Explanation Ref Debit Credit Balance
20 __
Nov. 6 2 3,734 7,734
20 2 8,390 12,124
30 To close 3 12,124 -0-

Income Summary Account No. 53

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 Revenue 3 12,124 12,124

19
Closing Entries for Expense Accounts

Expense accounts have debit balances. Closing an expense account means

transferring its debit balance to the Income Summary account. The journal
entry to close an expense account, therefore, consists of a credit to the
expense account in an amount equal to its debit balance, with an offsetting
debit to the Income Summary account.
There are six expense accounts in the ledger of Greenhill Real Estate. Six
separate journal entries could be made to close these six expense accounts, but
the use of one compound journal entry is an easier, time-saving method of
closing all six expense accounts. A compound journal entry is an entry that
includes debits to more than one account or credits to more than one account.

GENERAL JOURNAL Page No. 3

Date Account Title and Explanation LP Debit Credit
20 __
Nov. 30 Income Summary 53 9,724
Advertising Expense 70 630
Salaries Expense 72 7,100
Telephone Expense 74 144
Depreciation Expense- Building 76 150
Depreciation Expense- Off. Equipment 78 100
Income Taxes Expense 80 1,600
To close the Sales Commission Earned account

After the closing entry has been posted, the Income Summary account has a
credit balance of $2,400, and the six expense accounts have zero balances as
shown on the following page.

Closing Entries the Income Summary Accounts

The six expense accounts have now been closed and the total amount of $9,724
formerly contained in these accounts appears in the debit column of the
Income Summary. The Sales Commission of $12,124 earned during November
appears in the credit column of the Income Summary. Since the credit entry of
$12,124 representing November revenue is larger than the debit $9,724
representing November expenses, the account has a credit balance of $2,400 –
the net income for November.

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 Advertising Expense Account No. 70
Date Explanation Ref Debit Credit Balance
20 __
Nov. 1 2 360 360
16 2 270 630
30 To close 3 630 -0-

Salaries Expense Account No. 72

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 7,100 7,100
30 To close 3 7,100 -0-

Telephone Expense Account No. 74

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 144 144
30 To close 3 144 -0-

Depreciation Expense- Building Account No. 76

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 150 150
30 To close 3 150 -0-

Depreciation Expense- Office Equipment Account No. 78

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 100 100
30 To close 3 100 -0-

Income Tax Expense Account No. 80

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 2 1,600 1,600
30 To close 3 1,600 -0-

Income Summary Account No. 53

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 Revenue 3 12,124 12,124
30 Expense 3 9,724 2,400

21
The net income of $2,400 earned during November causes the owners’ equity to
increase. The credit balance of the Income Summary account is, therefore,
transferred to the Retained Earnings account by the following closing entry:

GENERAL JOURNAL Page No. 3

Date Account Title and Explanation LP Debit Credit
20 __
Nov. 30 Income Summary 53 2,400
Retained Earnings 51 2,400
To close the Income Summary account for November
by transferring the net income to the retained
earnings account

After the closing entry has been posted, the Income Summary account has a
zero balance, and the net income for November will appear as an increase or
credit entry in the Retained Earnings account, as shown below.

Income Summary Account No. 53

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 Revenue 3 12,124 12,124
30 Expense 3 9,724 2,400
30 To close 3 2,400 -0-

Retained Earnings Account No. 51

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 Net Income for November 3 2,400 2,400

In our illustration the business has operated profitably with revenue in excess
of expenses. Not every business is fortunate. If the expenses of a business are
larger than its revenues, the Income Summary account will have a debit
balance, representing a net loss for the accounting period. In this case, the
closing of the Income Summary account requires a debit to the Retained
Earnings account and an offsetting credit to the Income Summary account. A
debit balance in the Retained Earnings account is referred to as a deficit; it is
shown as a deduction from Capital Stock in the balance sheet.
Notice that the Income Summary account is used only at the end of the period
when the accounts are being closed. The Income Summary account has no
entries and no balance except during the process of closing the accounts at the
end of the accounting period.

22
Closing the Dividends Account

As explained earlier in the chapter, the payment of dividends to the owners is

not considered an expense of the business and therefore, is not taken into
account in determining the net income for the period. Since dividends do not
constitute an expense, the Dividends account is not closed into the Income
Summary account. Instead, it is closed directly to the Retained Earnings
account, as shown by the following entry:

GENERAL JOURNAL Page No. 3

Date Account Title and Explanation LP Debit Credit
20 __
Nov. 30 Retained Earnings 51 2,000
Dividends 52 2,000
To close the Dividends account

After this closing entry has been posted, the Dividends account will have a zero
balance, and the dividends declared during November will appear as a
deduction or debit entry in the Retained Earnings account, as follows:

Dividends Account No. 52

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 Declaration & payment 2 2,000 2,000
30 To close 3 2,000 -0-

Retained Earnings Account No. 51

Date Explanation Ref Debit Credit Balance
20 __
Nov. 30 Net Income for November 3 2,400 2,400
30 Dividends 3 2,000 400

Summary of the Closing Process

Let us now summarize the process of closing the accounts.

1. Close the various revenue accounts by transferring their balances into

the Income Summary account.
2. Close the various expense accounts by transferring their balances into
the Income Summary account.
3. Close the Income Summary account by transferring its balance into the
Retained Earnings account.
4. Close the Dividends account by transferring its balance into the Retained
Earnings account.

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After Closing Trial Balance

After the revenue and expense accounts have been closed, it is desirable to
prepare an after-closing trial balance, which of course will consist solely
of balance sheet accounts. There is always the possibility that an error in
posting the closing entries may have upset the equality of debits and credits
in the ledger. The after closing trial balance, or post-closing trial balance as
is often called, is prepared from the ledger. It gives assurance that the
accounts are in balance and ready for the recording of the transactions of
the new accounting period. The after-closing trial balance of Greenhill Real
Estate follows:

GREENHILL REAL ESTATE

After Closing Trial Balance
November 30, 20___
Cash …………………………………………. $ 10,074
Accounts Receivable ……………………. 9,590
Land …………………………………………. 52,000
Building ……………….…………………… 36,000
Accumulated Depreciation – Building $ 150
Office Equipment ……….…..………….. 12,000
Accumulated Depreciation– Office Equipment 100
Notes Payable ……………………………………… 30,000
Accounts Payable ……………………………….. 7,414
Income Taxes Payable …………………………. 1,600
Capital Stock …..………………………………… 80,000
Retained Earnings …………………................ 400
$119,664 $119,664

The Complete Accounting Cycle

In chapter two we introduced the concept of accounting cycle. Our illustration,
however, was limited to transactions affecting the balance sheet. Now we have
explained and illustrated a complete accounting cycle – from the initial
recording of transactions to the preparation of a “set” of financial statements.
The steps comprising this cycle are listed below.

1. Journalize transactions. Enter all transactions in the journal, thus

creating a chronological record of events.
2. Post to ledger accounts. Post debits and credits from the journal to the
proper ledger accounts, thus creating a record classified by accounts.
3. Prepare a trial balance. Prove the equality of debits and credits in the
ledger.
4. Prepare end-of-period adjustments. Draft adjusting entries in the
general journal, and post to the ledger accounts.

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 5. Prepare an adjusted trial balance. Prove again the equality of debits
and credits in the ledger. (Note: These are the amounts used in the
preparation of financial statements.)
6. Prepare financial statements and appropriate disclosures. An
income statement shows the results of operation for the period. A
statement of retained earnings shows changes in retained earnings during
the period and the closing balance. A balance sheet shows the financial
position of the business at the end of the period. Financial statements
should be accompanied bt notes disclosing facts necessary for the proper
interpretation of those statements.
7. Journalize and post the closing entries. The closing entries “zero” the
revenue, expense, and dividends accounts, making them ready for
recording the events of the next accounting period. These entries also
bring the balance in the retained Earnings account up-to-date.
8. Prepare an after-closing trial balance. The step ensures that the
ledger remains in balance after posting of the closing entries.

Some Concluding Remarks

Dividends – Declaration and Payment
Earlier in this chapter the declaration and payment of a cash dividend were
treated as a single event recorded by one journal entry. A small corporation with
only a few stockholders may choose to declare and pay a dividend on the same
day. In large corporations with thousands of stockholders and constant
transfers of shares, an interval of a month or more will separate the date of
declaration from the latter date of payment.

Assume for example that on April 1 the board of directors of Universal

Corporation declares the regular quarterly dividend of $1 per share on the 1
million shares of outstanding capital stock. The board’s resolution specifies that
the dividend will be payable on May 10 to stockholders of record on April 25. To
be eligible to receive the dividend, an individual must be listed on the
corporation’s records as a stockholder on April 25, the date of record. Two
entries are required: one on April 1 for the declaration of the dividend and one
on may 10 for its payment, as shown below:
Apr. 1 Dividends ………………………….. $1,000,000
Dividends Payable ……… $1,000,000
Declared dividend of $1 per share payable
may 10 to shareholders of record Apr. 10.

Apr. 1 Dividends Payable………………… $1,000,000

Cash …………………………... $1,000,000
Paid the $1 per share declared on Apr. 1.

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The Accrual basis of Accounting
The policy of recognizing revenue in the accounting records when it is earned,
and recognizing expenses when the related goods or services are used, is called
the accrual basis of accounting. The purpose of accrual accounting is to
measure the profitability of the economic activities conducted during the
accounting period.
The most important concept involved in accrual accounting is the matching
principle. Revenue is offset with all of the expenses incurred in generating that
revenue, thus providing a measure of the overall profitability of the economic
activity.
An alternative to the accrual basis is something called cash basis accounting.
Under the cash basis accounting, revenue is recognized when cash is collected
from the customer, rather than when the company sells goods or renders
services. Expenses are recognized when payment is made, rather than when the
related goods or services are used in business operations.
The cash basis of accounting measures the amount of cash received and paid
out during the period, but it does not provide a good measure of the profitability
of activities undertaken during the period.
Generally accepted accounting principles (GAAP) usually require use of the
accrual basis in measuring revenue, expenses, and net income. However, the
cash basis is acceptable for use in individuals’ income tax returns. (Remember
that income tax rules often differ from financial reporting requirements.) For
this reason some small businesses – especially sole proprietorships – use the
cash basis in their accounting records.

Adjusting Entries: A Closer Look

We introduce adjusting entries using as examples the entries to record
depreciation expense and income tax expense. We will now see that other types
of expenses – and also revenues – may require “adjustment” at the end of the
accounting period. But first, let us review the role of adjusting entries in the
accounting cycle.

The Need for Adjusting Entries

For purposes of measuring income and preparing financial statements, the life
of a business is divided into a series of accounting periods. This practice
enables decision makers to compare the financial statements of the successive
periods and to identify significant trends.
But measuring the net income of relatively short accounting period poses a
problem. Some transactions affect the revenue or expenses of more than one
period. Therefore, adjusting entries are needed at the end of each period. The
purpose of these entries is to assign to each period the appropriate amounts of
revenue and expenses.

26
In summary, adjusting entries are needed whenever transactions affect the
revenue or expenses of more than one accounting period. These entries
assign revenues to the periods in which they are earned, and expenses to the
periods in which the related goods or services are used.
In theory, a business could make adjusting entries on a daily basis. But as a
practical matter, these entries are made only at the end of the accounting
period. Thus, “adjusting the accounts” is an end-of-period procedure
associated with the preparation of financial statements.

Types of Adjusting Entries

The exact number of adjustments needed at the end of each accounting period
depends upon the nature of the company’s business activities. However, most
adjusting entries fall into one of four general categories.

1. Entries to apportion recorded costs. A cost that will benefit more than
one accounting period usually is recorded by debiting an asset account.
In each period that benefits from the use of this asset, an adjusting entry
is made to allocate a portion of the asset’s cost to expense. Examples
include insurance, rent, office supplies, building, and equipment.
2. Entries to apportion unearned revenues. A business may collect in
advance for services to be rendered to customers in future accounting
periods. The amount collected from customers in advance represents
liabilities called Unearned/Deferred Revenue. It appears in the
liability section of the balance sheet, not in the income statement
until it is settled by rendering services. In the period in which these
services are actually rendered, an adjusting entry is made to record the
portion of the revenue earned during the period. This adjusting entry
consists of a debit to Unearned (Deferred) Revenue account and a credit
to the appropriate. Examples include advance collections for future
services from customers.
3. Entries to record unrecorded expenses. An expense may be incurred in
the current accounting period even though no bill has yet been received
and payment will not occur until a future period. Such unrecorded
expenses are recorded by an adjusting entry made at the end of the
accounting period. This adjusting entry consists of a debit to an
appropriate expense account and a credit to accounts payable. Examples
include unpaid salaries, interest on borrowed money, and corporate
income taxes.
4. Entries to apportion unrecorded revenues. Revenue may be earned
during the current period, but not yet billed to customers or recorded in
the accounting records. Such unrecorded revenue is recorded by making
an adjusting entry at the end of the period. This adjusting entry consists
of a debit to an accounts receivable and a credit to the appropriate
revenue account. Examples include uncollected revenue.

27
Each type of adjusting entry is directly related either to past or future
transactions.

Characteristics Adjusting Entries

It will be helpful to keep in mind two important characteristics of all

adjusting entries.

First, every adjusting entry involves the recognition of either revenue or

expense. Revenue and expenses represent changes in owners’ equity. However,
owners’ equity cannot change by itself; there also must be a corresponding
change in either assets or liabilities. Thus, every adjusting entry affects both
an income statement (revenue or expense) and a balance sheet account
(asset or liability).

Second, adjusting entries are based upon the concepts of accrual accounting,
not upon monthly bills or month-end transactions. No one sends us a bill
saying, “Depreciation expense on your building amounts to $150 this month.”
Yet, we must be aware of the need to estimate and record depreciation expense
if we are to measure net income properly for the period. Making adjusting
entries requires a greater understanding of accrual accounting concepts than
does the recording of routine business transactions. In many businesses, the
adjusting entries are made by the company’s controller or by a professional
accountant, rather than by the regular accounting staff.

----ENDS------

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