1. Chapter 3: The Matching Concept and the Adjusting Process

2. I. Matching Concept
Reporting revenues and expenses incurred to create the revenue are reported in the same accounting period.

3. Question
If rent for May is paid on June 1, in which month will be reported as rent expense?
May?
June?

4. Answer:
It depends on whether the business is run in a “cash basis” or an “accrual basis”
Accrual basis: May
Cash basis: June
Accrual basis: revenues reported as earned; expenses reported when incurred, e.g., matching the expenses to the revenues recorded.
Cash basis: revenues reported when received; expenses reported when paid.

5. Accrual Basis Business Applies for Loan and Required to Provide List of Monthly Expenses
Checkbook shows the following checks:
$375: rent
$110: utilities
$200: car payment
$480: ½ year of car insurance
$120: 1 year of life insurance
$20: paying for credit purchases last year

6. How to Report? Rent: ? Utilities: ? Car Payment: ? Car insurance: ?
Life insurance: ?
Credit Card: ?

7. Answer: Rent: Same as check Utilities: Same as check
Car Payment: Same as check
Car insurance: 480/6 months = $80/month
Life insurance: $120/12 = $10/month
Credit Card: Same as check
Note: If entire insurance payments are reported as monthly expenses, monthly expenses will be overstated.
Illustration of the “matching” concept.

8. Similar problem:
What if the business had received $10,000 loan, with principal and interest of 12% to be paid 12 months after receipt of funds?
Issue?

9. Issue: Not all business expenses for the month are paid monthly.
The business must consider all expenses incurred for the month:
$10000(.12)= $1200/year = $120/month

10. Similar problem:
What if the business made $100 in sales to customers but payment not received until 2 months later?
Must show $200 revenue earned for the period even though unpaid.
GAAP: Net Income: Revenues earned from sale of services during the period – expenses incurred in providing those services.
Match expenses against revenues they generate

11. Accrual basis accounting requires adjusting entries
How much of the Accounts Receivables earned during the month?
How much of the Supplies were used during the month?

12. Exercise: Net Income for Brick Layers Inc. for the month of June
$1200: Fees earned for a brick patio.
$400: Bricks purchased on account to be paid in July.
$20: 2 cement bags purchased and paid in June
$200: laborers’ pay at the end of the work.
$600/moth: Other monthly expenses paid for rent, utilities, insurance, etc.

13. NET INCOME Revenues: ? Expenses: Net Profit: ? Bricks:? Cement: ?
Wages: ?
Other expenses: ?
Net Profit: ?

14. NET INCOME Revenues: ? Expenses: Net Profit: ? Bricks:? Cement: ?
Wages: ?
Other expenses: ?
Net Profit: ?

15. Net Income Revenues: 1200 Expenses: Net Profit: 430 Bricks: 400
Cement: 20
Wages: 200
Other expenses: ¼ of $600: $150
Total Expenses
Net Profit:

16. II. Adjusting Entries Why?
Accrual basis requires that we update accounting records so that all revenues earned and all expenses incurred are properly recorded.

17. Types of adjusting entries:
Deferral = cash transfers hands in current period in payment for performance in future periods.
Deferred cash today for future performance
Accruals = Performance in current period and cash transfers hands in future periods.
Accrue performance today for future cash

18. Deferrals: Deferred Expense:
When you pay for an item in advance (before it is actually used), e.g., a prepaid expense.
1st recorded as an asset.
As the asset is used, adjusting entries reflect a transfer from the asset to an expense:
Supplies
Prepaid insurance

19. Supplies: Recorded as an asset when purchased.
As supplies are used each month, an adjusting entry is required to transfer the cost of supplies from an asset account to an expense account.

20. Example
On December 5, the business purchased $250 in supplies. On 12/31 the ending inventory in supplies was $50.
Original entry
Supplies…………………………250
Cash…………………………..250
Adjusting entry
Supplies expense…………….. 200
Supplies…………………...….200

21. Prepaid insurance: Recorded as an asset when purchased.
As the policy expires, each month the asset is being used up.
So an adjusting entry is required to transfer the cost of insurance from an asset account to an expense account

22. Example
On December 1, the business purchased a 6-month insurance policy. On December 31, how do you record insurance?
Original entry
Prepaid insurance………. 600
Cash…………………….. 600
Adjusting entry
Insurance Expense……….. 100
Prepaid Insurance………100

23. Deferred revenue:
Occurs when you get paid before you earn it, e.g., unearned revenues.
Cash has been received for goods but as goods have not been delivered, the cash has not being earned.
Records receipt of cash against a liability that reflects unearned revenues, e.g., a promise to deliver goods or services in the future.
After delivery, revenues are earned, so a corresponding portion of the liability is transferred to revenue, e.g., revenue is recognized.

24. Example
On 11/2 the business received 3 months rent in advance or $2400. What is the entry at EOY?
Original entry
Cash …………………
Unearned rent ……………..2400
Adjusting entry
Unearned rent……………1600
Rent income
Note: “unearned” = liability in Balance Sheet; “earned” = revenue in Income Statement

25. Accruals Accrued expense: expenses incurred before payment.
Assume electricity is paid on the 15th of the following month: A daily utility expense is incurred but not paid. Others: Accrued wages, accrued interest.
Accrued revenues: revenues are earned but not recorded. A business is not paid for services rendered during the month until the 10th of the following month. Other: accrued interest on notes receivable.

26. Example
On Wednesday 12/31, the business owes $500 in wages. Payroll is Friday.
Original entry: None
Adjusting entry:
Wages Expense… …500
Wages Payable……………….500

27. Example At EOY the business is owed $80 in interest.
Original entry: None
Adjusting entry:
Interest receivable ……………80
Interest Income…………………..80

28. Depreciation
Applicable only to assets with a long life, e.g., fixed assets
While use of supplies is reflected by the quantity used, e.g., total supplies decreases as used, one building continues to be one building. However, as the equipment gets older, performance decreases.
The decrease in performance or usefulness is known as “depreciation”.
Decrease for the period is a function of “useful life”.
Useful life is an artificially created # of years the asset is expected to be useful.

29. Recording Depreciation
Depreciation expense reflects the periodic decrease in the building usefulness for the period being reported.
Debit Depreciation Expense
Credit Accumulated Depreciation
Contra asset account
Asset increases are denoted with debits
Contra asset increases are denoted with credits
Do not credit the original asset. Prices are reflected at their original cost.

30. An analogy
You need 4 tires. One set costs $200 with a life estimate of 20,000 miles. The other set costs $300 with a life estimate of 40,000 miles. If you drive 10,000 miles/year and are keeping the car for at least 4 years, which is the best buy?

31. Estimating Cost
$200 set is estimated to last 20,000 miles or 2 years. Thus, cost = $100/year
$300 set is estimated to last 40,000 miles or 4 years. Thus cost = $75/year.
Upon purchase of $300 set, it is recorded as an asset. Every year, $75 is transferred to an expense account.
Original entry
Tires……………………………….300
Cash………………………………..……300
Adjusting entry at EOY:
Depreciation expense…………..…75
Accumulated Depreciation…………….75

32. Exercise:
An accrual business buys a building in an area where real estate is increasing at 6%/year. You record depreciation.
Why record depreciation when values are going up?

33. Answer Depreciation is not related to the value of the asset.
Depreciation is an estimate of the asset’s usefulness that has expired during the period.
The original cost and the accumulated depreciation are reported in the Balance Sheet. Two separate accounts.

34. Exercise: Prepare journal entries from trial balances
Unadjusted/Adjusted:
Supplies 200/140
Prepaid insurance 400/210
Wages Payable 0/130
Unearned revenue 100/30
Fees earned: 7200/7330
Supplies expense 0/60
Insurance expense 0/190

35. Answer Supplies expense…………60 Supplies………………………60
Expl: Supplies at BOY=200; EOY=140
Insurance expense……….190
Prepaid insurance…………….190
Expl: Prepaid insurance BOY:400; EOY 210
Wages Expense……………….130
Wages Payable………………130
Expl: $130 wages accrued but not paid at EOY
Unearned Revenue……………70
Fees earned ……………………..70
Expln: Unearned fees at EOY