measuring business income: the adjusting process

Measuring Business Income:

The Adjusting Process

Distinguish accrualaccounting from

cash-basis accounting.

Objective 1

Accrual-basis:Transactions are

recordedwhen revenues are

earned 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-Basis Accounting

2002 2003 2004(000 omitted)

Revenues $50 $50 $50Expenses 20 20 20Net income (loss) $30 $30 $30


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

Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries

1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed.

Deferrals3. Accrued Revenues.

Revenues earned but not yet received in cash or recorded.

4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned.

Accruals

LO 4 Identify the major types of adjusting entries.LO 4 Identify the major types of adjusting entries.

Deferrals are either:

Prepaid expenses

OR

Unearned revenues.

Adjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for Deferrals

LO 5 LO 5 Prepare adjusting entries for deferrals.Prepare adjusting entries for deferrals.

Payment of cash, that is recorded as an asset because service or benefit will be received in the future.

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

insuranceinsurance

suppliessupplies

advertisingadvertising

Cash Payment

Cash Payment

Expense Recorded

Expense Recorded

BEFORE


rentrent

maintenance on maintenance on equipmentequipment

fixed assets fixed assets (depreciation)(depreciation)

Prepayments often occur inPrepayments often occur in

Prepaid Expenses

Costs that expire either with the passage of time or through use.

Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts.





Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.

Illustration 3-4Illustration 3-4

Example Example (Insurance)(Insurance):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $12,000 for 12 months of insurance Consulting paid $12,000 for 12 months of insurance coverage. Show the journal entry to record the coverage. Show the journal entry to record the payment on Jan. 1payment on Jan. 1stst. .

Cash 12,000

Prepaid Insurance 12,000

Jan. 1

Debit Credit

Prepaid Insurance

12,00012,000 12,00012,000

Debit Credit

Cash



Example Example (Insurance)(Insurance):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $12,000 for 12 months of insurance Consulting paid $12,000 for 12 months of insurance coverage. Show the coverage. Show the adjusting journal entryadjusting journal entry required at required at Jan. 31Jan. 31stst. .

Prepaid Insurance 1,000

Insurance Expense 1,000Jan. 31

Debit Credit

Prepaid Insurance

12,00012,000 1,0001,000

Debit Credit

Insurance Expense

1,0001,000

11,00011,000



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.


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


What was the determining factor in matching this expense?

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



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

Accrued Salaries Expenses 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.


What is the April 30 adjusting entry? April 30, 2005

Accrued service Receivable 15,000 Service Revenue

15,000 To accrue service revenue

Performance


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.

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

Buildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.

Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life (Matching Principle).

Adjusting Entries for “Adjusting Entries for “Depreciation””Adjusting Entries for “Adjusting Entries for “Depreciation””


Example Example (Depreciation)(Depreciation):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $24,000 for equipment that has an estimated Consulting paid $24,000 for equipment that has an estimated useful life of 20 years. Show the journal entry to record the useful life of 20 years. Show the journal entry to record the purchase of the equipment on Jan. 1purchase of the equipment on Jan. 1stst. .

Cash 24,000

Equipment 24,000Jan. 1

Debit Credit

Equipment

24,00024,000 24,00024,000

Debit Credit

Cash

Adjusting Entries for “Adjusting Entries for “DepreciationDepreciation””Adjusting Entries for “Adjusting Entries for “DepreciationDepreciation””


Example Example (Depreciation)(Depreciation):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $24,000 for equipment that has an Consulting paid $24,000 for equipment that has an estimated useful life of 20 years. Show the estimated useful life of 20 years. Show the adjusting journal adjusting journal entryentry required at Jan. 31 required at Jan. 31stst. . ($24,000 / 20 yrs. / 12 ($24,000 / 20 yrs. / 12 months = $100)months = $100)

Accumulated Depreciation 100Depreciation Expense 100Jan. 31

Debit Credit

Depreciation Expense

100100 100100

Debit Credit

Accumulated Depreciation

Adjusting Entries for “Adjusting Entries for “DepreciationDepreciation””Adjusting Entries for “Adjusting Entries for “DepreciationDepreciation””


Depreciation (Statement Presentation)

Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment) on the balance sheet.

Adjusting Entries for “Adjusting Entries for “Depreciation””Adjusting Entries for “Adjusting Entries for “Depreciation””


Balance Sheet J an. 31

Assets

Equipment 24,000 Accumulated Depreciation (100) Net Equipment 23,900

Depreciation Example

On January 2, Wood Enterprise purchased a truck for $30,000 cash.

The truck is expected to last for 3 years.


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


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


Prensa InsuranceStatement of Owner’s Equity


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


Prensa InsuranceBalance Sheet


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


Trial BalanceTrial Balance – Each account is analyzed to determine whether it is complete and up-to-date.

Phoenix Consulting - J an. 31st (before adjusting entries)Acct. No. Account Debit Credit

100 Cash 50,000$ 105 Accounts receivable 35,000 110 Prepaid insurance 12,000 120 Equipment 24,000 130 I nvestments 300,000 200 Accounts payable 20,000$ 210 Unearned revenue 24,000 220 Note payable 200,000 300 Austin, capital 40,000 400 Sales 137,000

421,000$ 421,000$

Trial BalanceTrial BalanceTrial BalanceTrial Balance

LO 4 Identify the major types of adjusting entries.LO 4 Identify the major types of adjusting entries.

measuring business income: the adjusting process

Documents

maymatching expenses

recording expenses

assign expenses

yearly expenses

cash outflows

cash examplein

cash receipts

payment of cash