3 - 1 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Business Income: The Adjusting Process Chapter 3

3 - 2 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Distinguish accrual-basis accounting from cash-basis accounting. Objective 1

3 - 3 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrual-basis: Transactions are recorded when revenues are earned or expenses are incurred. 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. Cash-basis: Transactions are recorded when cash is paid or cash is received. The Two Bases of Accounting:

3 - 4 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrual Versus Cash Example l In January 2002, Prensa Insurance sells a three-year health insurance policy to a business client. l The contract specifies that the client had to pay $150,000 in advance. l Yearly expenses amount to $20,000. l What is the income or loss?

3 - 5 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrual Versus Cash Example Accrual-Basis Accounting (000 omitted) Revenues$50$50$50 Expenses Net income (loss)$30$30$30

3 - 6 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrual Versus Cash Example Cash-Basis Accounting (000 omitted) Cash inflows$150$ 0$ 0 Cash outflows Net income (loss)$130($20)($20)

3 - 7 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Managers adopt an artificial period of time to evaluate performance. Managers adopt an artificial period of time to evaluate performance. Accounting Period

3 - 8 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Monthly Quarterly Semi-annually Interim Period Statements

3 - 9 ©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Apply the revenue and matching principles. Objective 2

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Revenue Principle l When is revenue recognized? l When it is deemed earned. l Recognition of revenue and cash receipts do not necessarily occur at the same time.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber The Matching Principle l What is the matching principle? l It is the basis for recording expenses. l Expenses are the costs of assets and the increase in liabilities incurred in the earning of revenues. l Expenses are recognized when the benefit from the expense is received.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Matching Expenses with Revenues Example l Parker Floor sells a wood floor for $15,000 on the last day of May. l The wood was purchased from the manufacturer for $8,000 in March of the same year. l The floor is installed in June. l When is income recognized?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Revenues$15,000 Cost of goods sold 8,000 Net income$ 7,000 May Matching Expenses with Revenues Example

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Interacts with the revenue principle and the matching principle Requires that income be measured accurately each period The Time Period Concept l It requires that accounting information be reported at regular intervals.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Make adjusting entries at the end of the accounting period. Objective 3

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Adjusting Entries l Assign revenue to the period earned. l Assign expenses to the period incurred. l Bring related asset and liability accounts into correct balance.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Prepaids or Deferrals Accruals Two Types Of Adjusting Entries

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Prepaid expenses Depreciation Accrued expenses Accrued revenues Unearned revenues Five Categories Of Adjusting Entries

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 24,000 CashPrepaid Insurance 24,000 Prepaid Insurance Example On January 2, 2002, Parker Floor paid $24,000 for a two-year health insurance policy.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Prepaid Insurance Example l What is the journal entry on December 31, 2002? l Dec. 31, 2002 Insurance Expense 12,000 Prepaid Insurance 12,000 To record insurance expense

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Time Prepaid Insurance Example l What was the determining factor in matching this expense?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Supplies Example l Wood Enterprise started business the beginning of the month. l $800 worth of office supplies were purchased on November 15, 2001, for cash.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Office SuppliesCash 800 An inventory at month end indicated that $200 in office supplies remained. What is the supplies expense? Supplies Example

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Usage Supplies Expense 600 Supplies Bal. 200 Supplies Example What was the determining factor in matching this expense?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Depreciation Example l On January 2, Wood Enterprise purchased a truck for $30,000 cash. l The truck is expected to last for 3 years.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Depreciation Example l The cost of the truck must be matched with the accounting periods in which it was used to earn income. l What is the journal entry for the year ended December 31, 2002?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Dec. 31, 2002 Depreciation Expense 10,000 Accumulated Depreciation 10,000 To record depreciation on machinery Depreciation Example

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 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. Accumulated depreciation is a contra account to plant assets. Contra Accounts

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Wood Enterprise Example Partial Balance Sheet December 31, 2002 Plant assets: Machinery$30,000 Less: Accumulated depreciation 10,000 Total$20,000 Contra account Book value

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accruals l What is an accrual? l It is the recognition of an expense or revenue that has arisen but has not yet been recorded. l Expenses or revenues are recorded before the cash settlement.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrued Expenses Example l Employees at Mary Business Services are paid every Friday. l Weekly salaries total $30,000. l The business is closed on Saturday and Sunday. l The employees were last paid on April 26, which was a Friday. l They will be paid on May 3.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber April May Accrued Expenses Example

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrued Expenses Example l What is the adjusting entry on April 30? l They worked April 29 and 30. l $30,000 ÷ 5 = $6,000 per day l $6,000 × 2 days = $12,000 l April 30, 2002 Salaries Expense 12,000 Salaries Payable 12,000 To accrue salary expense

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrued Revenues Example l During the month of April, Mary Business Services rendered services to customers totaling $15,000. l At the end of April, the customers have not as yet been billed.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accrued Revenues Example l What is the April 30 adjusting entry? l April 30, 2002 Accounts Receivable 15,000 Service Revenue 15,000 To accrue service revenue

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Performance Accrued Revenues Example l What is the determining factor in recognizing this service revenue?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Unearned or Deferred Revenue Example l In January 2002, Prensa Insurance received $150,000 from a business client to provide health insurance coverage for three years. l January 2, 2002 Cash 150,000 Unearned Revenue 150,000 Received revenue in advance

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Correct liability $100,000 Correct liability $100,000 Total accounted for $150,000 Total accounted for $150,000 Correct revenue $50,000 Correct revenue $50,000 Unearned or Deferred Revenue Example l What is the journal entry on December 31, 2002? l Unearned revenue 50,000 Revenue 50,000 To record revenue collected in advance

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Notice l Adjusting entries always have... – one income statement account and... – one balance sheet account. l Adjusting entries never involve cash.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Prepare an adjusted trial balance. Objective 4

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Adjusted Trial Balance l The adjusting process starts with the unadjusted trial balance. l Adjusting entries are made at the end of the accounting period and then an adjusted trial balance is prepared. l The adjusted trial balance serves as the basis for the preparation of the financial statements.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Prepare the financial statements from the adjusted trial balance. Objective 5

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Financial Statements l Financial statements have two parts: 1 The first part includes the following: – name of the entity – title of the statement – date or period covered 2 The second part is the body of the statement.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 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, 2002

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 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 Statement of Owner’s Equity Year Ended December 31, 2002

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 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 Insurance Balance Sheet Year Ended December 31, 2002

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 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 Financial Statements Example

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber End of Chapter 3