Measuring Business Income: The Adjusting Process

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Measuring Business IncomeThe Adjusting Process

• Chapter 3

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Objective 1

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

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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.
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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?

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Accrual Versus Cash Example
Accrual-Basis Accounting
2002 2003 2004
(000 omitted)
Revenues 50 50 50 Expenses 20
20 20 Net income (loss) 30 30 30
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Accrual Versus Cash Example
Cash-Basis Accounting
2002 2003 2004
(000 omitted)
Cash inflows 150 0 0 Cash
outflows 20 20 20 Net income
(loss) 130 (20) (20)
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Accounting Period
Managers adopt an artificial period of time to
evaluate performance.
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Interim Period Statements
Monthly
Quarterly
Semi-annually
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Objective 2

• Apply the revenue andmatching principles.

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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.

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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.

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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?

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Matching Expenses with Revenues Example
May
Revenues 15,000 Cost of goods sold
8,000 Net income 7,000
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The Time Period Concept

• It requires that accounting information be
  reported at regular intervals.

Interacts with the revenue principle and the
matching principle
Requires that income be measured accurately each
period
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Objective 3

• Make adjusting entries.

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Adjusting Entries

• Assign revenue to the period earned.
• Assign expenses to the period incurred.
• Bring related asset and liability accounts into
  correct balance.

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Two Types OfAdjusting Entries
Prepaids or Deferrals
Accruals
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Five Categories OfAdjusting Entries
Prepaid expenses
Accrued revenues
Depreciation
Unearned revenues
Accrued expenses
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Prepaid Insurance Example

• On January 2, 2005, Parker Floor paid 24,000
• for a two-year health insurance policy.

Cash
Prepaid Insurance
24,000
24,000
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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

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Prepaid Insurance Example

• What was the determining factor in matching this
  expense?

Time
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Supplies Example

• Wood Enterprise started business the beginning of
  the month.
• 800 worth of office supplies were purchased on
  November 15, 2004, for cash.

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Supplies Example
Office Supplies
Cash
800
800
An inventory at month end indicated that 200 in
office supplies remained. What is the supplies
expense?
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Supplies Example
Supplies Expense
Supplies
800 600 Bal. 200
600

• What was the determining factor in matching this
  expense?

Usage
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Depreciation Example

• On January 2, Wood Enterprise purchased a truck
  for 30,000 cash.
• The truck is expected to last for 3 years.

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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?

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Depreciation Example

• Dec. 31, 2005
• Depreciation Expense 10,000
• Accumulated Depreciation 10,000
• To record depreciation on truck

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Contra Accounts
A contra account has a companion account.
A contra accounts normal balance is opposite
that of the companion account.
Accumulated depreciation is a contra account
to plant assets.
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Wood Enterprise Example
Partial Balance Sheet December 31, 2005
Plant assets Machinery 30,000 Less
Accumulated depreciation 10,000 Total
20,000
Contra account
Book value
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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.

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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.

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Accrued Expenses Example
April
May
1 2 3
26 27
28 29 30
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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
  Salaries Expense 12,000
  Salaries Payable 12,000
  To accrue salary expense

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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.

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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

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Accrued Revenues Example

• What is the determining factor in recognizing
  this service revenue?

Performance
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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

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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

Total accounted for 150,000
Correct revenue 50,000
Correct liability 100,000
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Notice

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

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Objective 4

• Prepare an adjusted
• trial balance.

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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.

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Objective 5

• Prepare the financial
• statements from the
• adjusted trial balance.

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Financial Statements

• Financial statements have two parts
• The first part includes the following
• name of the entity
• title of the statement
• date or period covered
• The second part is the body of the statement.

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Financial Statements Example
Prensa Insurance Income Statement Year Ended
December 31, 2005
Revenue from insurance services 50,000 Less Sala
ries expense 14,275 Supplies expense
250 Rent expense 3,600 Utilities
expense 625 Interest expense
600 Depreciation 650 Net
income 30,000
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Financial Statements Example
Prensa Insurance Statement of Owners Equity Year
Ended December 31, 2005
Prensa Insurance Equity, January 1,
2002 100,000 Add Net income
30,000 Prensa Insurance Equity, December 31,
2002 130,000
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Financial Statements Example
Prensa Insurance Balance Sheet Year Ended
December 31, 2002
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
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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 Owners equity 130,000 Total
liabilities and owners equity 200,000
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End of Chapter 3