Measuring Business Income:
The Adjusting ProcessChapter 3
Distinguish accrualaccounting from
cash-basis accounting.
Objective 1
Accrual-basis:Transactions are
recordedwhen revenues areearned or expenses
are incurred.
Cash-basis:Transactions arerecorded whencash is paid or
cash is received.
The Two Bases of Accounting:
Accrual Versus Cash Example
In January 2002, Prensa Insurance sells a three-year health insurance policy to a business client.
The contract specifies that the client had to pay $150,000 in advance.
Yearly expenses amount to $20,000. What is the income or loss?
Accrual Versus Cash Example
Accrual-Basis Accounting
2002 2003 2004(000 omitted)
Revenues $50 $50 $50Expenses 20 20 20Net income (loss) $30 $30 $30
Accrual Versus Cash Example
Cash-Basis Accounting
2002 2003 2004(000 omitted)
Cash inflows $150 $ 0 $ 0Cash outflows 20 20 20Net income (loss) $130 ($20) ($20)
Managers adopt anartificial period of time
to evaluate performance.
Accounting Period
Monthly
Quarterly
Semi-annually
Interim Period Statements
Apply the revenue and
matching principles.
Objective 2
Revenue Principle
When is revenue recognized? When it is deemed earned. Recognition of revenue and cash receipts
do not necessarily occur at the same time.
The Matching Principle
What is the matching principle? It is the basis for recording expenses. Expenses are the costs of assets and the
increase in liabilities incurred in the earning of revenues.
Expenses are recognized when the benefit from the expense is received.
Matching Expenses with Revenues Example Parker Floor sells a wood floor for $15,000
on the last day of May. The wood was purchased from the
manufacturer for $8,000 in March of the same year.
The floor is installed in June. When is income recognized?
Revenues $15,000Cost of goods sold 8,000Net income $ 7,000
May
Matching Expenses with Revenues Example
Interacts with the revenue principle and the matching principle
Requires that income be measured
accurately each period
The Time Period Concept
It requires that accounting information be reported at regular intervals.
Make adjusting entries.
Objective 3
Adjusting Entries
Assign revenue to the period earned. Assign expenses to the period incurred. Bring related asset and liability accounts
into correct balance.
Prepaids or Deferrals
Accruals
Two Types OfAdjusting Entries
Prepaid expenses
Depreciation
Accrued expenses
Accrued revenues
Unearned revenues
Five Categories OfAdjusting Entries
24,000
CashPrepaid Insurance
24,000
Prepaid Insurance Example
On January 2, 2005, Parker Floor paid $24,000
for a two-year health insurance policy.
On January 2, 2005, Parker Floor paid $24,000
for a two-year health insurance policy.
Prepaid Insurance Example
What is the journal entry on December 31, 2005?
Dec. 31, 2005 Insurance Expense 12,000
Prepaid Insurance 12,000 To record insurance expense
Time
Prepaid Insurance Example
What was the determining factor in matching this expense?
Supplies Example
Wood Enterprise started business the beginning of the month.
$800 worth of office supplies were purchased on November 15, 2004, for cash.
Office Supplies Cash
800 800
An inventory at month end indicatedthat $200 in office supplies remained.
What is the supplies expense?
An inventory at month end indicatedthat $200 in office supplies remained.
What is the supplies expense?
Supplies Example
Usage
Supplies Expense600
Supplies 800 600
Bal. 200
Supplies Example
What was the determining factor in matching this expense?
Depreciation Example
On January 2, Wood Enterprise purchased a truck for $30,000 cash.
The truck is expected to last for 3 years.
Depreciation Example
The cost of the truck must be matched with the accounting periods in which it was used to earn income.
What is the journal entry for the year ended December 31, 2005?
Dec. 31, 2005
Depreciation Expense 10,000
Accumulated Depreciation 10,000
To record depreciation on truck
Depreciation Example
A contra account has a companion
account.A contra account’s normal balance is opposite that of the companion
account.Accumulateddepreciation is a contra account to
plant assets.
Contra Accounts
Wood Enterprise Example
Partial Balance SheetDecember 31, 2005
Plant assets:Machinery $30,000Less: Accumulated depreciation 10,000
Total $20,000
Plant assets:Machinery $30,000Less: Accumulated depreciation 10,000
Total $20,000
Contra accountBook valueBook value
Accruals
What is an accrual? It is the recognition of an expense or
revenue that has arisen but has not yet been recorded.
Expenses or revenues are recorded before the cash settlement.
Accrued Expenses Example
Employees at Mary Business Services are paid every Friday.
Weekly salaries total $30,000. The business is closed on Saturday and
Sunday. The employees were last paid on April 26,
which was a Friday. They will be paid on May 3.
April May
26 27
28 29 30
1 2 3
Accrued Expenses Example
Accrued Expenses Example
What is the adjusting entry on April 30? They worked April 29 and 30. $30,000 ÷ 5 = $6,000 per day $6,000 × 2 days = $12,000 April 30, 2002
Salaries Expense 12,000 Salaries Payable 12,000
To accrue salary expense
Accrued Revenues Example
During the month of April, Mary Business Services rendered services to customers totaling $15,000.
At the end of April, the customers have not as yet been billed.
Accrued Revenues Example
What is the April 30 adjusting entry? April 30, 2005
Accounts Receivable 15,000 Service Revenue
15,000 To accrue service revenue
Performance
Accrued Revenues Example
What is the determining factor in recognizing this service revenue?
Unearned or Deferred Revenue Example In January 2005, Prensa Insurance received
$150,000 from a business client to provide health insurance coverage for three years.
January 2, 2005 Cash 150,000
Unearned Revenue 150,000 Received revenue in advance
Correctliability
$100,000
Totalaccounted for
$150,000
Correctrevenue$50,000
Unearned or Deferred Revenue Example What is the journal entry on December 31,
2005? Unearned revenue 50,000
Revenue 50,000 To record revenue collected in advance
Notice
Adjusting entries always have...– one income statement account and...– one balance sheet account. Adjusting entries never involve cash.
Prepare an adjusted
trial balance.
Objective 4
Adjusted Trial Balance
The adjusting process starts with the unadjusted trial balance.
Adjusting entries are made at the end of the accounting period and then an adjusted trial balance is prepared.
The adjusted trial balance serves as the basis for the preparation of the financial statements.
Prepare the financialstatements from the
adjusted trial balance.
Objective 5
Financial Statements
Financial statements have two parts:1 The first part includes the following:– name of the entity– title of the statement– date or period covered2 The second part is the body of the
statement.
Financial Statements Example
Revenue from insurance services $50,000Less: Salaries expense 14,275
Supplies expense 250Rent expense 3,600Utilities expense 625Interest expense 600Depreciation 650
Net income $30,000
Revenue from insurance services $50,000Less: Salaries expense 14,275
Supplies expense 250Rent expense 3,600Utilities expense 625Interest expense 600Depreciation 650
Net income $30,000
Prensa InsuranceIncome Statement
Year Ended December 31, 2005
Prensa Insurance Equity, January 1, 2002 $100,000Add: Net income 30,000Prensa Insurance Equity, December 31, 2002 $130,000
Financial Statements Example
Prensa InsuranceStatement of Owner’s Equity
Year Ended December 31, 2005
Assets: Cash $189,150 Accounts receivable 5,000 Supplies inventory 100 Prepaid rent 1,000 Office equipment 5,000 Less: Accumulated depreciation 250
Total assets $200,000
Financial Statements Example
Prensa InsuranceBalance Sheet
Year Ended December 31, 2002
Liabilities and Equities: Utilities payable $ 150 Interest payable 600 Accounts payable (supplies) 250 Salaries payable 4,100 Bank loan 64,900Total liabilities $ 70,000
Owner’s equity 130,000Total liabilities and owner’s equity $200,000
Financial Statements Example
End of Chapter 3