managerial accounting

Managerial Accounting - 2.1

Measuring Business Income:The Adjusting Process

Chapter 3


It’s Just Lunch

Disappointed by blind dates and personal ads,

– Andrea McGinty founded a prescreened lunch dating service.


It’s Just Lunch

In 1996, the business earned revenues of $4.5 million.

Also, the business earned a net income of $400,000.

How was this number computed? Expenses were deducted from revenues to

determine net income.


Chapter Objectives

1 Distinguish accrual-basis accounting from cash-basis accounting.

2 Apply the revenue and matching principles.


Chapter Objectives

3 Make adjusting entries at the end of the accounting period.

4 Prepare an adjusted trial balance.5 Prepare the financial statements from the

adjusted trial balance.


Distinguish accrual-basis accounting from cash-basis

accounting.

Objective 1


The Two Bases of Accounting:

1 Accrual-basis2 Cash-basis


Accrual Basis

Accountants record transactions...– when revenues are earned,– or when expenses are incurred,– regardless of when cash changes hands.


Cash Basis

Accountants record transactions...– when cash is paid,– or when cash is received,– regardless of when a revenue is earned or

an expense is incurred.


Remember GAAP?

Generally Accepted Accounting Principles GAAP requires that a business use the accrual

basis.


GAAP

Accountants record revenues as they are earned...

– and expenses as they are incurred,– not necessarily when cash is received or

paid.


Accrual Accounting

Using accrual accounting, Its’ Just Lunch records revenue when it sells dating services, not when it collects cash later.

Likewise, It’s Just Lunch records expenses when incurred.


Example

Salary expense not only includes amounts paid to employees,

– it includes any amount owed to employees.


Dennis’ Landscaping

Services performed during the month of July - $15,000.

Cash collected from customers - $6,000. Expenses for the month - $12,000. Cash paid out - $9,000.


Cash Basis

Revenues are the cash collected from customers - $6,000.

Expenses are the cash paid out during the month - $9,000.


Cash Basis

Dennis’ Landscaping lost $3,000 during the month of July.


Cash Basis Revenue: $15,000 Cash In: $6,000

Expenses: $12,000 Cash Out: $9,000

Dennis’ Landscaping Income Statement For the Month

Ended July 31, 19xx

Revenues $6,000

Expenses 9,000

Net Loss $3,000


Accrual Basis

Revenues of $15,000 are recognized for the services performed during the month.

Expenses are the $12,000 incurred during the month.


Accrual Basis

Dennis’ Landscaping made a profit of $3,000.


Cash Accrual

Dennis’ Landscaping Income Statement For the Month Ended July

31, 19xx Revenues $6,000 Expenses 9,000 Net Loss

$3,000

Dennis’ Landscaping Income Statement For the Month Ended July

31, 19xx Revenues $15,000 Expenses 12,000 Net Income $

3,000

Managerial Accounting - 2.21Why Does GAAP Requirethe Accrual Basis?

Because accrual accounting provides a more complete portrayal of operating performance and financial position.


Problems with Cash Basis

Over or understatement of...– Revenue– Expense– Accounts receivable– Accounts payable


The Time Period Concept...

– requires that accounting information be reported at regular intervals.

– requires that income be measured accurately each period.


Accounting Period

Managers adopt an artificial period of time to evaluate performance.

Managerial Accounting - 2.25The Annual Accounting Period Can Be...

– a calendar year (January 1st to December 31st), or

– a fiscal year (any consecutive 12-month period).


Interim Period Statements...

– are prepared for less than one year. Monthly Quarterly Semi-annually


Objective 2

Apply the revenue andmatching principles.


Revenue Principle

Revenue is recognized when it is deemed earned.

Recognition of revenue and cash receipts do not necessarily occur at the same time.

Cash could be received at the same time. Cash could be received after the earning. Cash could be received before the earning.


The Matching Principle...

– is the basis for recording expenses. Expenses are the costs of assets and the

increase in liabilities incurred in the earning of revenues.


Expense Recognition

Expenses are recognized when the benefit from the expense is received.

Recognition of expenses and cash payments do not necessarily occur at the same time.


The Time Period Concept...

– allows businesses to report accounting information on a regular basis.

– interacts with the revenue principle and the matching principle to underlie the use of accruals.


The Time Period Concept

In order to measure income accurately, businesses update the revenue and expense accounts before the end of the period.


Objective 3

Make adjusting entries at the end of the accounting

period.


Adjusting Entries

At the end of the period accountants prepare financial statements.

This end-of-period process starts with the unadjusted trial balance.


Adjusting Entries...

– are made to bring accounts to correct balances before preparing financial statements.


Adjusting Entries...

– assign revenue to period earned.– assign expenses to the period incurred.– bring related asset and liability accounts

into correct balance.

Managerial Accounting - 2.37Two Types OfAdjusting Entries

1 Prepaids2 Accruals


Prepaids

A prepaid, or deferral, is the postponement of the recognition of an expense already paid or incurred or a revenue already received.


Prepaid Expenses

These are goods or services paid for in advance that do not expire during the current accounting period.

They include miscellaneous assets that will expire or will be used up in the near future.


Prepaid Expenses

Examples:– Prepaid rent– Prepaid insurance– Supplies– Buildings– Equipment


Prepaid Expenses

On January 2, 19x1, Dennis’ Landscaping paid $1,200 for a one year insurance policy. Prepaid Insurance Cash

1,200 1,200


Prepaid Expenses

Jan. 2, 19x1 Prepaid Insurance 1,200 Cash 1,200 Paid insurance


Prepaid Expenses

This insurance expense must be matched to the months to which it applies.

What is the journal entry on January 31, 19x1?


Prepaid Expenses

On January 31, 19x1, one month of the 12-month insurance policy has expired.

$1,200/12 = $100 Jan. 31, 19x1 Insurance

expense 100 Prepaid insurance 100 One month’s insurance premium


???????

What was the determining factor in matching this expense?

Time


Supplies

Wordcrafters started business the beginning of the month.

$500 worth of office supplies were purchased on March 15, 19x1, for cash.


Supplies

Office Supplies Cash

500 500

Office Supplies 500 Cash or Accounts Payable 500

Purchased office supplies


Supplies

An inventory at month end indicated that $120 in office supplies remained.

Therefore, $380 worth of supplies was used during the month ($500 - $120).


Supplies

The cost of supplies must be matched to the period in which they were used.

What is the journal entry on March 31, 19x1?


Supplies

Mar. 31, 19x1 Office Supplies Expense 380 Office Supplies 380

One month’s usage of supplies Supplies Expense Supplies 380 500 380 Bal. 120


???????

What was the determining factor in matching this expense?

Usage


Depreciation of Plant Assets

Plant assets are large prepaid expenses.


Depreciation...

– is a cost allocation of a long-lived asset. Depreciation expense is the cost converted

from an asset to an expense. Estimates are used.



On January 2nd, the business purchased a truck for $30,000 cash.

The truck is expected to last for 3 years.


Journalizing

January 2, 19x1 Machinery 30,000 Cash 30,000

Purchase of truck


Matching Principle

The cost of the truck must be matched with the accounting periods in which it was used to earn income.

What would the journal entry be for the year ended December 31, 19x1?


Straight Line Method

Cost: $30,000 Service life: 3 Years Cost/Estimated useful life $30,000/3 = $10,000 per year


Depreciation Expense

Dec. 31, 19x1 Depreciation Expense 10,000 Accumulated Depreciation 10,000

To record depreciation expense for a one-year period


Contra Accounts

A contra account is one that is paired with and deducted from another related account in the financial statements.

Normal balance is opposite its companion account.

Accumulated depreciation is a contra account to plant assets.


Book Value...

– is the cost of an asset that has not been depreciated.



Partial Balance Sheet December 31, 19x1

Plant Assets Machinery $30,000 Less Accumulated Depreciation 10,000 $20,000

Contra account Book value



Partial Balance Sheet December 31, 19x2

Plant Assets Machinery $30,000 Less Accumulated Depreciation 20,000 $10,000

Contra account Book value


Accruals

An accrual is the recognition of an expense or revenue that has risen but has not yet been recorded.

Expenses or revenues are recorded before the cash settlement.


Accrued Expenses...

– are expenses that have been incurred but not yet paid.


Accrued Expenses

Employees of Mary Business Services are paid every Friday.

Weekly salaries total $30,000.


Accrued Expenses

Mary’s is closed on Saturday and Sunday. The employees were last paid on April

26th, which was a Friday.


Accrued Expenses

The employees will be paid on May 3rd. What is the adjusting entry on April

30th? They worked April 29th and 30th. $30,000/5 = $6,000 per day $6,000 x 2 days = $12,000


Accrued Expenses

Apr. 30, 19x1 Salaries Expense 12,000 Salaries Payable 12,000

To accrue two days salaries


Accrued Revenues

These are revenues that have been earned but not yet received.

They are an asset.


Accrued Revenues

During the month of August, Dennis’ Landscaping rendered services to customers totaling $15,000.

At the end of August, the customers have not as yet been billed.


Accrued Revenues

What is the August 31st adjusting entry? August 31, 19x1 Accounts

Receivable 15,000 Service Revenue 15,000 To record unpaid invoices


????????

What is the determining factor in recognizing this service revenue?

Performance


Unearned Revenue

Collecting cash from customers in advance of doing work creates a liability called unearned revenue.


Unearned Revenue

Examples:– Commissions collected In advance– Season tickets to sporting events– Magazine subscriptions


Unearned Revenue

On September 1, 19x1, a football team received $200,000 from season ticket holders to attend 16 games.


Unearned Revenue

Sept. 1, 19x1 Cash 200,000 Unearned Ticket Revenue 200,000

Season ticket receipts


Unearned Revenue

Four of the sixteen games had been played by September 30, 19x1.

What would the journal entry be?


Unearned Revenue

Revenue per game = $200,000/16 $12,500 $12,500 x 4 = $50,000


Unearned Revenue

Sept. 30, 19x1 Unearned ticket revenue 50,000 Ticket revenue 50,000

To record four games


Notice

Adjusting entries always have:– one income statement account and– one balance sheet account. Adjusting entries never involve cash.


Objective 4

Prepare an adjusted trial balance.


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.


Adjusted Trial Balance

The adjusted trial balance verifies the equality of debits and credits after the adjusting process.

It serves as the basis for the preparation of the financial statements.

The adjusted trial balance is an internal statement.


Objective 5

Prepare the financial statements from the adjusted

trial balance.


Prepare the Statements

The adjusted trial balance is an internal statement used to prepare the financial statements.

Financial statements are external statements.


Financial Statements

The financial statements are:– Income Statement– Statement of Owners’ Equity– Cash Flow Statement– Balance Sheet


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.

Managerial Accounting - 2.88Relationships Among the Statements

The income statement reports net income or net loss.

Net income or net loss is determined by subtracting expenses from revenues.


Revenues and expenses are owners’ equity account.

Net income or net loss is transferred to the statement of owners’ equity.


Capital is a balance sheet account. The ending balance in the statement of

owners’ equity is transferred to the balance sheet.


The statement of cash flow explains the cause for the change in the cash balance between two balance sheets dates.


Completing the Accounting Cycle

Chapter 4


Motorola Company

This company is best known for its computer chips, cellular phones and other electronic products.

In order to successfully compete, Motorola gets its financial data to management quickly.


Motorola

Motorola accomplishes this goal by rapidly closing its books.

Motorola can close its accounts in just two days.


Chapter Objectives

1 Prepare an accounting work sheet.2 Use the work sheet to complete the

accounting cycle.3 Close the revenue, expense and withdrawal

accounts.


Chapter Objectives

4 Correct typical accounting errors.5 Classify assets and liabilities as current or

long-term.6 Use the current and debt ratios to evaluate a

business.


The Accounting Cycle

The accounting cycle is the process by which accountants prepare financial statements for an entity for a specific period of time.


The Accounting Cycle

For a new business, begin by setting up ledger accounts.

For an established business, begin with account balances carried over from the previous period.


Work Performed This Period

Start with the account balances in the ledger at the beginning of the period.

Analyze and journalize transactions. Post journal entries to the ledger accounts.


End of Period Work

Compute the unadjusted balance in each account.

Make adjustments. Prepare the adjusted trial balance. Prepare the financial statements.


End of Period Work

Journalize and post the adjusting entries. Journalize and post the closing entries. Prepare the post closing trial balance. This

trial balance readies the accounts for the next period.


Objective 1

Prepare an accounting

work sheet.


Accounting Work Sheet

A work sheet is a multi-columned document used by accountants to help move data from the trial balance to the financial statements.

It is an internal document.


Steps in Preparingthe Work Sheet

Enter the account titles. Then enter the unadjusted ending balances

in the trial balance column and total.


The Accounting Work SheetAdjusted Trial Balance

ACCOUNT TITLE DEBIT CREDIT DEBIT CREDIT DEBIT CREDITCASH 12,100ACCTS RECEIVABLE 1,350SUPPLIES 250EQUIPMENT 15,500ACCUM DEPRECIATION 7,500ACCOUNTS PAYABLE 1,200SALARY PAYABLE 1,100UNEARNED REVENUE 1,500CAPITAL 7,200WITHDRAWALS 1,000REVENUE 23,700SALARY EXPENSE 12,000

TOTALS 42,200 42,200

TRIAL BALANCE ADJUSTMENTS ADJ. TRIAL BAL.


Adjustments

a The company has earned revenue of $1,700 which will be collected next month.

b Inventory of supplies at month end totaled $150.

c Depreciation for the period was calculated as $200.



ACCOUNT TITLE DEBIT CREDIT DEBIT CREDIT DEBIT CREDITCASH 12,100ACCTS RECEIVABLE 1,350 a) 1,700SUPPLIES 250 b) 100EQUIPMENT 15,500ACCUM DEPRECIATION 7,500 c) 200ACCOUNTS PAYABLE 1,200SALARY PAYABLE 1,100UNEARNED REVENUE 1,500CAPITAL 7,200WITHDRAWALS 1,000REVENUE 23,700 a) 1,700SALARY EXPENSE 12,000SUPPLIES EXPENSE b) 100DEPRECIATION EXP c) 200 TOTALS 42,200 42,200 2,000 2,000




ACCOUNT TITLE DEBIT CREDIT DEBIT CREDIT DEBIT CREDITCASH 12,100 12,100ACCTS RECEIVABLE 1,350 a) 1,700 3,050SUPPLIES 250 b) 100 150EQUIPMENT 15,500 15,500ACCUM DEPRECIATION 7,500 c) 200 7,700ACCOUNTS PAYABLE 1,200 1,200SALARY PAYABLE 1,100 1,100UNEARNED REVENUE 1,500 1,500CAPITAL 7,200 7,200WITHDRAWALS 1,000 1,000REVENUE 23,700 a) 1,700 25,400SALARY EXPENSE 12,000 12,000SUPPLIES EXPENSE b) 100 100DEPRECIATION EXP c) 200 200 TOTALS 42,200 42,200 2,000 2,000 44,100 44,100




ACCOUNT TITLE DEBIT CREDIT DEBIT CREDIT DEBIT CREDITCASH 12,100 12,100ACCTS RECEIVABLE 3,050 3,050SUPPLIES 150 150EQUIPMENT 15,500 15,500ACCUM DEPRECIATION 7,700 7,700ACCOUNTS PAYABLE 1,200 1,200SALARY PAYABLE 1,100 1,100UNEARNED REVENUE 1,500 1,500CAPITAL 7,200 7,200WITHDRAWALS 1,000 1,000REVENUE 25,400SALARY EXPENSE 12,000SUPPLIES EXPENSE 100DEPRECIATION EXP 200 TOTALS 44,100 44,100 31,800 18,700

ADJ. TRIAL BAL. INC. STATEMENT BALANCE SHEET



ACCOUNT TITLE DEBIT CREDIT DEBIT CREDIT DEBIT CREDITCASH 12,100 12,100ACCTS RECEIVABLE 3,050 3,050SUPPLIES 150 150EQUIPMENT 15,500 15,500ACCUM DEPRECIATION 7,700 7,700ACCOUNTS PAYABLE 1,200 1,200SALARY PAYABLE 1,100 1,100UNEARNED REVENUE 1,500 1,500CAPITAL 7,200 7,200WITHDRAWALS 1,000 1,000REVENUE 25,400 25,400SALARY EXPENSE 12,000 12,000SUPPLIES EXPENSE 100 100DEPRECIATION EXP 200 200 TOTALS 44,100 44,100 12,300 25,400 31,800 18,700




ACCOUNT TITLE DEBIT CREDIT DEBIT CREDIT DEBIT CREDITCASH 12,100 12,100ACCTS RECEIVABLE 3,050 3,050SUPPLIES 150 150EQUIPMENT 15,500 15,500ACCUM DEPRECIATION 7,700 7,700ACCOUNTS PAYABLE 1,200 1,200SALARY PAYABLE 1,100 1,100UNEARNED REVENUE 1,500 1,500CAPITAL 7,200 7,200WITHDRAWALS 1,000 1,000REVENUE 25,400 25,400SALARY EXPENSE 12,000 12,000SUPPLIES EXPENSE 100 100DEPRECIATION EXP 200 200 TOTALS 44,100 44,100 12,300 25,400 31,800 18,700

NET INCOME 13,100 13,10025,400 25,400 31,800 31,800



Objective 2

Use the work sheet to complete the accounting cycle.


Recording theAdjusting Entries

The work sheet helps identify the accounts that need adjustments.

Actual adjustment of the accounts requires journalizing and posting the entries.


Recording theAdjusting Entries

The adjusting entries may be recorded in the journal when they are entered on the work sheet.

Many accountants journalize and post the adjusting entries just before they make the closing entries.


Objective 3

Close the revenue, expense and withdrawal accounts.


Closing the Accounts

Closing the accounts is the end of period process that prepares the accounts for recording transactions during the next period.



What accounts are closed at the end of the period?

Revenue, Expenses and Withdrawals. These relate to a specific period and are

called temporary accounts.


Income Summary

The Income Summary account is used to close the temporary accounts.

This is the “most temporary” account. It is used only to facilitate the closing

process.



Revenues and Expense accounts are closed to Income Summary.

Income Summary is closed to Capital. Withdrawals are closed to Capital.



Net income will be represented by a credit balance in the Income Summary.

Net loss by a debit balance.


Flowchart of Closing Process

Revenue Income Summary12,000

7,500 9,000

Salary Exp 3,300

28,500

1,500 1,800

4,450 28,500

Rent Exp 800 800

Supplies Exp 350 350

24,050

24,050

(Close Revenue Account)

(Close Expense Accounts)

(Close Income Summary)

Withdrawals2,500 2,500

2,500

Capital Account

(Close Withdrawals Account)


Postclosing Trial Balance

The accounting cycle ends with the postclosing trial balance.

The postclosing trial balance is dated as of the end of the period for which the statements have been prepared.


Permanent Accounts

These never close :– Assets– Liabilities– Owners’ equity Balances of permanent accounts carry over

to the next period.


Objective 4

Correct typical

accounting errors.


Correcting Errors

Suppose that Dennis’ Landscaping bought supplies for $3,000 and erroneously debited equipment.


Correcting Errors

What was the incorrect entry? Debit Equipment and credit Cash. What is the correcting entry? Debit Supplies and credit Equipment.


Objective 5

Classify assets and liabilities as current or long-term.


Liquidity

This is a measure of how quickly an item can be converted to cash.


Current or Long-term

On the balance sheet, assets and liabilities are classified as either current or long-term to indicate their relative liquidity.


Assets are Classified asCurrent or Long-term

Current assets are cash, or will be converted to cash, in one year or within the normal business operating cycle.

– Cash– Short term receivables– Inventory– Prepaid expenses


Assets are Classified asCurrent or Long-term

Long-term assets include all other assets.

– Property, equipment and intangibles


Liabilities are Classified as Current or Long-term

Current liabilities are debts or obligations due within one year or within the operating cycle.

– Accounts and salary payables– Short term notes payable– Unearned revenue


Liabilities are Classified as Current or Long-term

Long-term liabilities are all other debts due in longer than one year or the entity’s operating cycle.


The Classified Balance Sheet

The debit side– Current assets– Long-term assets Assets are listed in order of decreasing

liquidity.


The Classified Balance Sheet

The credit side– Current liabilities– Long-term liabilities Liabilities are listed in the order of how

soon they must be paid.

Managerial Accounting - 2.136 Classified Balance Sheet XYZ Services

January 31, 19xx Assets Liabilities

Current Assets Current Liabilities

Cash 12,100 Accounts Payable 1,200

Accounts Receivable 3,050 Salary Payable 1,100

Supplies 150 Unearned Revenue 1,500

Total Current Assets 15,300 Total Liabilities 3,800

Plant Assets Owners’ Equity

Equipment 15,500 Capital 19,300

Less Accum Deprec 7,700 7,800

Total Liabilities and Total Assets 23,100 Equity

23,100


Different Formats ofthe Balance Sheet

The report format lists assets first, then liabilities and then owners’ equity.

The account format reports assets on the left side and liabilities and owners’ equity on the right side.


Objective 6

Use the current and debt ratios to evaluate a business.


Comparative Financial Statements...

– are statements that show two or more consecutive periods.

They enhance the user’s ability to analyze a company’s past performance.


Evaluating with Ratios

Two common ratios used to measure liquidity are:

1 Current ratio2 Debt ratio


Current Ratio

This measures the ability of a business to pay its current liabilities with its current assets.


Current Ratio

Current assets/Current liabilities A ratio of 1.0 or more indicates that a

business should have no trouble paying its current bills.


Debt Ratio

It indicates the proportion of a business’ assets that are financed with debt.

It measures their ability to pay both current and long-term debt.


Debt Ratio

Total liabilities/Total assets The lower the ratio, the safer.


Trend Analysis

Decision makers compare various ratios over a period of time, looking for improving trends.

managerial accounting - 2.1 measuring business income: the adjusting process chapter 3

Documents

cashbasis accounting

accrual accounting

accrualbasis accounting

cashbasis slide

bases of accounting

accounting period

cash basis revenues