Measuring Business Income:
The Adjusting Process
Chapter 3
Objective 1
Distinguish accrual accounting from cash-basis
accounting.
The Two Bases of Accounting:
Accrual-basis: Transactions are recorded
when revenues are earned or expenses are incurred.
Cash-basis: Transactions are recorded when cash is paid or cash is received.
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
(000 omitted) | 2002 | 2003 | 2004 |
Revenues | $50 | $50 | $50 |
Expenses | 20 | 20 | 20 |
Net income (loss) | $30 | $30 | $30 |
Accrual Versus Cash Example
Cash-Basis Accounting
(000 omitted) | 2002 | 2003 | 2004 |
Cash inflows | $150 | $ 0 | $ 0 |
Cash outflows | 20 | 20 | 20 |
Net income (loss) | $130 | ($20) | ($20) |
Managers adopt an artificial period of time to evaluate performance.
Accounting Period
Interim Period Statements
Monthly
Quarterly
Semi-annually
Objective 2
Apply the revenue
and matching principles.
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?
Matching Expenses with Revenues Example
Revenues | $15,000 |
Cost of goods sold | 8,000 |
Net income | $ 7,000 |
May
The Time Period Concept
Interacts with the revenue principle and the matching principle
Requires that income be measured accurately each period
It requires that accounting information be reported at regular intervals.
Objective 3
Make adjusting
entries.
Adjusting Entries
Assign revenue to the period earned. Assign expenses to the period incurred.
Bring related asset and liability accounts into correct balance.
Two Types Of
Adjusting Entries
Prepaids or Deferrals
Accruals
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What are the types of Adjusting entries?
Five Categories Of
Adjusting Entries
Prepaid expenses
Depreciation
Accrued expenses
Accrued revenues
Unearned revenues
Prepaid Insurance Example
On January 2, 2005, Parker Floor paid
$24,000
for a two-year health insurance policy.
Prepaid Insurance Cash 24,000 24,000
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
Prepaid Insurance Example
Time
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.
Supplies Example
Office Supplies
Cash
800
800
An inventory at month end indicated that $200 in office supplies remained.
What is the supplies expense?
Supplies Example
Usage
Supplies Expense
600
Supplies 800 600
Bal. 200
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?
Depreciation Example
10,000
Dec. 31, 2005
Depreciation Expense
Accumulated Depreciation 10,000
To record depreciation on truck
Contra Accounts
A contra account has a companion account.
A contra account’s normal balance is opposite that of the companion account.
Accumulated depreciation is a contra account to plant assets.
Wood Enterprise Example
Partial Balance Sheet December 31, 2005
Plant assets: Machinery
Less: Accumulated depreciation Total
$30,000
10,000
$20,000
Contra account
Book 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.
Accrued Expenses Example
April | ||||||
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| | | | | | |
| | | | | 26 | 27 |
28 | 29 | 30 | | | | |
May | ||||||
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| | | 1 | 2 | 3 | |
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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
12,000
Salaries Expense 12,000 Salaries Payable
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 Service Revenue
15,000
15,000
To accrue service revenue
Accrued Revenues Example
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
Unearned or Deferred Revenue Example
Correct liability
$100,000
Total accounted for
$150,000
Correct revenue
$50,000
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...
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.
The adjusted trial balance serves as the basis for the preparation of the financial statements.
Objective 5
Prepare the financial statements from the adjusted trial
balance.
Financial Statements
Financial statements have two parts:
1 The first part includes the following:
2 The second part is the body of the statement.
Financial Statements Example
Revenue from insurance services | $50,000 |
Less: Salaries expense | 14,275 |
Supplies expense | 250 |
Rent expense | 3,600 |
Utilities expense | 625 |
Interest expense | 600 |
Depreciation | 650 |
Net income | $30,000 |
Prensa Insurance Income Statement
Year Ended December 31, 2005
Financial Statements Example
Prensa Insurance Equity, January 1, 2002 Add: Net income
Prensa Insurance Equity, December 31, 2002
$100,000
30,000
$130,000
Prensa Insurance Statement of Owner’s Equity
Year Ended December 31, 2005
Financial Statements Example
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 Insurance Balance Sheet
Year Ended December 31, 2002
Financial Statements Example
Liabilities and Equities: Utilities payable | $ 150 |
Interest payable | 600 |
Accounts payable (supplies) | 250 |
Salaries payable | 4,100 |
Bank loan | 64,900 |
Total liabilities | $ 70,000 |
Owner’s equity | 130,000 |
Total liabilities and owner’s equity | $200,000 |
End of Chapter 3