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