We will now see that there is more to the measurement of business income than merely recording transactions. 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, an insurance policy that’ covers 12 months, or-as Overnight has done enough supplies to last for several month
Shop Supplies: An Asset That Turns into an Expense
On December 4″ Overnight purchased for $1,400 a quantity of shop supplies expected to last for three or four months. At the date of purchase, this $1,400 cost was debited to an asset account (Shop Supplies), because it was expected to benefit future accounting .’ periods. But as these supplies are used, this asset gradually becomes an expense. This concept is illustrated in the fOllowi~g diagram:
Assume th8t during December, $400 worth of Overnight’s shop supplies was used in business operations and that approximately suxo worth remains on hand-available for use in future periods. The $400 of supplies used during December should be recognized as expense in that month; the $1,000 in supplies still on hand should appear in the December 31 balance sheet as an asset. . .
To transfer the cost of the supplies used during the month from-the asset account to an expense account, Overnight Willmake the following adjusting entry at December 31:
The idea of shop supplies being used up over several months is easy to understand. But did you know the same concept applies to assets such as buildings, automobiles, and even railroad tracks?
The Concept of Depreciation
Depreciable assets are physical objects that retain their size and shape but that eventually wear out or become obsolete.’ They are not physically consumed, as are assets such .as supplies, but nonetheless their. economic usefulness diminishes over time. Examples of depreciable assets include buildings and all types of equipment, fixtures, fumishingsand even railroad tracks. Land, however, is not viewed as a depreciable asset, as it has an unlimited useful life.
Each period, a portion of a 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 cost of a depreciable asset to expense over the asset’s useful life. This process is illustrated below:
Depreciation on the Tools and Equipment
Overnight also must record depreciation on its tools and equipment. These assets cost $12,000, and management estimates that they will remain in service. for about five years. Thus the monthly depreciation expense amounts to $200 ($12,000 cost + 60 months). The adjusting entry to recognize this monthly expense is:
Similar adjusting entries to recognize depreciation expense on the building and tools and equipment will be made each month throughout the assets’ useful’ lives. Depreciation begins when the assets are placed in use for the intended business purpose. 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 did not recognize depreciation on these assets in November, because Over operated for only part of the month.)
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 on page 106 because it includes several new account titles, and the balances in some existing accounts have been adjusted.
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 tM exception of the owner’s capital account. During the accounting period, many transactions affecting owner’s equity were not recorded directly in the owner’s capital account. Rather, these transactions were recorded in the various revenue and expense accounts or in the owner’s drawing account. Therefore, the balance in the owner’s capital account shown in the adjusted trial balance is not completely up to date. This will not cause a problem; as we prepare financial statements, the amount of the owner’s equity the end of the period will become apparent.
PREPARING FINANCIAL STATEMENTS·
Now that Overnight Auto Service 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 operations-whether the month’s activities have been profitable or unprofitable. To provide this additional information, we-will prepare a more complete set of financial statements, consisting of an income statement, a statement of owner’s equity, a balance sheet, and a statement of cash flows. These statements are illustrated on pages 114 and 115,
The Income Statement
The revenue and expenses shown in the income statement are. taken directly from the company’s adjusted trial balance. Overnight’s income statement for December shows that revenue’ exceeded the expenses for the month, thus producing a net income of $3,900. 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
An income statement has certain limitation~. Remember that the amounts shown for ‘ depreciation expense are based on estimates of the useful lives of the company’s building and office equipment. Also, the income statement includes only those events that have been evidenced by business transactions. Perhaps during December, Overnight’s advertising has caught the attention of many potential customers. A good “customer base” is certainly an important step toward profitable operations. However, the development of a customer base is not reflected in the income statement because its value cannot be measured objectively until actual transactions take place. Despite these limitations, the income statement is of vital importance and indicates that the new business has been profitable during its first month of operation.
Alternative titles for the income statement include earnings statement, statement’of operations, and profit and loss statement. 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 the revenue earned during a given time period with the expenses incurred in obtaining that revenue
The Balance Sheet
.The balance sheet lists the amounts of the company’s assets, liabilities, and o~’s equity at the,end of the accounting period. The balances of the asset and liability aecounts are taken directly from the adjusted trial balance on page 112. The amount of owner’s equity at the end of the period, $82,600, was determined in the statemen: of owner’s ‘ equity.
As shown in all the balance sheets we have illustrated, cash is listed first among the assets. It is often’ followed by such assets as marketable securities, short-term notes receivable; accounts receivable, inventories, and supplies. These are the most common examples of current assets. The term “current assets” includes cash and those assets that will be quickly converted to cash or used up in operations.
day-to-day revenue and expense transactions that are included in the income statement. Cash flows from investing activities are the cash effects of purchasing and selling longterm assets such as plant and equipment. Cash flows from financing activities are the cash effects of owners having invested in the company, creditors having loaned money . to the company, any repayments made to creditors, or any cash withdrawals from the company by the owners The statement of cash flows for Overnight Auto Service for the month of December is shown below
The cash balance of $14,220 shown in the statement of cash flows is identical to the cash balance shown in the company’s balance sheet. Take note that Overnight spent $2,380 more than it took in during the month of December. Furthermore, its statement of cash flows reports a net cash outflow of $280 from operating activities, even though its income statement reports a profit of $3,900 for the same period. While these issues are certainly cause for concern, they are not an uncommon. occurrence for’ new businesses just starting out.
Relationship Among the Financial Statements
A set of financial statements becomes easier to understand if we recognize that the income statement, statement of owner’s equity, balance sheet, and statement of cash flows all are related to one another. In others words, they articulate.
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 owner’s equity at the respective balance sheet dates. The statement of owner’s equity summarizes the changes in owner’s equity occurring between these two balance sheet dates. The income statement explains in greater detail the change in owner’s equity resulting from profitableor unprofitable-operation of the business. Thus the income statement and the statement of owner’s equity provide informative links between successive balance sheets.
The statement of cash flows reconciles the company’s beginning cash balance with its ending cash balance. Furthermore, it helps to explain changes during the period to (I) the company’s investment in property, plant, and equipment; (2) its outstanding debt; and (3) the coinponents of owner’s equity.