Measuring Business Income: The Adjusting Process Chapter 3

cash-basis accounting. 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)

Accounting Period Managers adopt an artificial period of time to evaluate performance.

Interim Period Statements Monthly Quarterly Semi-annually

Apply the revenue and matching principles. 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 May Revenues $15,000 Cost of goods sold 8,000 Net income $ 7,000

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

Make adjusting entries. 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

Five Categories Of Adjusting Entries Prepaid expenses Accrued revenues Depreciation Accrued expenses 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 What was the determining factor in matching this expense? Time

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?

What was the determining factor in matching this expense? Supplies Example Supplies Expense Supplies 800 600 Bal. 200 600 What was the determining factor in matching this expense? Usage

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 Dec. 31, 2005 Depreciation Expense 10,000 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 $30,000 Less: Accumulated depreciation 10,000 Total $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 May 1 2 3 26 27 28 29 30

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

Accrued Revenues Example What is the determining factor in recognizing this service revenue? Performance

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 What is the journal entry on December 31, 2005? Unearned revenue 50,000 Revenue 50,000 To record revenue collected in advance Correct liability $100,000 Total accounted for $150,000 Correct revenue $50,000

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. The adjusted trial balance serves as the basis for the preparation of the financial statements.

adjusted trial balance. Objective 5 Prepare the financial statements from the adjusted trial balance.

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.

Financial Statements Example Prensa Insurance Income Statement Year Ended December 31, 2005 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

Financial Statements Example Prensa Insurance Statement of Owner’s 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

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

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