CH 03

Measuring Business Income: The Adjusting Process Chapter 3
2002 Prentice Hall, Inc.
Business Publishing
Accounting, 5/E
Horngren/Harrison/Bamber
3-1
Objective 1
Distinguish accrual-basis accounting from cash-basis accounting.
Business Publishing
Accounting, 5/E
3-2
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.
Business Publishing
Accounting, 5/E
3-3
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?
2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3-4

Accrual-Basis Accounting
(000 omitted)
2002
2003
$50 20 $30
2004
$50 20 $30
Revenues $50 Expenses 20 Net income (loss) $30
Business Publishing
Accounting, 5/E
3-5

Cash-Basis Accounting
(000 omitted)
2002
2003
$ 0 20 ($20)
2004
$ 0 20 ($20)
Cash inflows $150 Cash outflows 20 Net income (loss) $130
Business Publishing
Accounting, 5/E
3-6
Accounting Period
Managers adopt an artificial period of time to evaluate performance.
Business Publishing
Accounting, 5/E
3-7
Interim Period Statements
Monthly
Quarterly Semi-annually
Business Publishing
Accounting, 5/E
3-8
Objective 2
Apply the revenue and matching principles.
Business Publishing
Accounting, 5/E
3-9
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.
Business Publishing
Accounting, 5/E
3 - 10
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.
2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 11
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 Cost of goods sold Net income $15,000 8,000 $ 7,000
Business Publishing
Accounting, 5/E
3 - 13
The Time Period Concept
It requires that accounting information be reported at regular intervals. Requires that income be measured accurately each period
Interacts with the revenue principle and the matching principle
Business Publishing
Accounting, 5/E
3 - 14
Objective 3
Make adjusting entries at the end of the accounting period.
Business Publishing
Accounting, 5/E
3 - 15
Adjusting Entries
Assign revenue to the period earned. Assign expenses to the period incurred. Bring related asset and liability accounts into correct balance.
Business Publishing
Accounting, 5/E
3 - 16
Two Types Of Adjusting Entries
Prepaids or Deferrals
Accruals
Business Publishing
Accounting, 5/E
3 - 17
Five Categories Of Adjusting Entries

Prepaid expenses Accrued revenues
Depreciation
Accrued expenses
2002 Prentice Hall, Inc. Business Publishing
Unearned revenues
Accounting, 5/E
3 - 18
Prepaid Insurance Example

On January 2, 2002, Parker Floor paid $24,000 for a two-year health insurance policy.
Prepaid Insurance 24,000
Cash 24,000
Business Publishing
Accounting, 5/E
3 - 19

What is the journal entry on December 31, 2002? Dec. 31, 2002 Insurance Expense 12,000 Prepaid Insurance 12,000 To record insurance expense
Business Publishing
Accounting, 5/E
3 - 20
What was the determining factor in matching this expense?
Time
Business Publishing
Accounting, 5/E
3 - 21
Supplies Example
Wood Enterprise started business the beginning of the month. $800 worth of office supplies were purchased on November 15, 2001, for cash.
Business Publishing
Accounting, 5/E
3 - 22
Supplies Example
Office Supplies 800 Cash 800
An inventory at month end indicated that $200 in office supplies remained. What is the supplies expense?
Supplies Example
Supplies Expense 600 Supplies 800 600
Bal. 200
What was the determining factor in matching this expense?

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E
Usage
3 - 24
Depreciation Example
On January 2, Wood Enterprise purchased a truck for $30,000 cash. The truck is expected to last for 3 years.
Business Publishing
Accounting, 5/E
3 - 25
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, 2002?
Business Publishing
Accounting, 5/E
3 - 26
Dec. 31, 2002 Depreciation Expense 10,000 Accumulated Depreciation 10,000 To record depreciation on machinery
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Accounting, 5/E
3 - 27
Contra Accounts
A contra account has a companion account.
Accumulated depreciation is a contra account to plant assets.

2002 Prentice Hall, Inc. Business Publishing
A contra accounts normal balance is opposite that of the companion account.
Accounting, 5/E
3 - 28
Wood Enterprise Example

Partial Balance Sheet December 31, 2002
Plant assets: Machinery Less: Accumulated depreciation Total Contra account Book value
$30,000 10,000 $20,000
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.
Business Publishing
Accounting, 5/E
3 - 30
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.

April May 1 2 3
26 27
28 29 30

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.
Business Publishing
Accounting, 5/E
3 - 34

What is the April 30 adjusting entry? April 30, 2002 Accounts Receivable 15,000 Service Revenue 15,000 To accrue service revenue
Business Publishing
Accounting, 5/E
3 - 35
What is the determining factor in recognizing this service revenue?

Performance
Business Publishing
Accounting, 5/E
3 - 36
Unearned or Deferred Revenue Example

In January 2002, Prensa Insurance received $150,000 from a business client to provide health insurance coverage for three years. January 2, 2002 Cash 150,000 Unearned Revenue 150,000 Received revenue in advance
Business Publishing
Accounting, 5/E
3 - 37
Unearned or Deferred Revenue Example

What is the journal entry on December 31, 2002? Unearned revenue 50,000 Revenue 50,000 To record revenue collected in advance
Correct liability $100,000

Total accounted for $150,000

Business Publishing Accounting, 5/E
Correct revenue $50,000

Horngren/Harrison/Bamber 3 - 38
Notice
Adjusting entries always have... one income statement account and... one balance sheet account. Adjusting entries never involve cash.
Business Publishing
Accounting, 5/E
3 - 39
Objective 4
Prepare an adjusted trial balance.
Business Publishing
Accounting, 5/E
3 - 40
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.
Business Publishing
Accounting, 5/E
3 - 42
Financial Statements
1
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.
Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 43
Financial Statements Example

Prensa Insurance Income Statement Year Ended December 31, 2002 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 Statement of Owners Equity Year Ended December 31, 2002 Prensa Insurance Equity, January 1, 2002 Add: Net income Prensa Insurance Equity, December 31, 2002
$100,000 30,000 $130,000
Business Publishing
Accounting, 5/E
3 - 45

Prensa Insurance Balance Sheet Year Ended December 31, 2002
Assets: Cash Accounts receivable Supplies inventory Prepaid rent Office equipment Less: Accumulated depreciation Total assets
$189,150 5,000 100 1,000 5,000 250 $200,000


Liabilities and Equities: Utilities payable Interest payable Accounts payable (supplies) Salaries payable Bank loan Total liabilities Owners equity Total liabilities and owners equity
150 600 250 4,100 64,900 $ 70,000 130,000 $200,000

End of Chapter 3
Business Publishing
Accounting, 5/E
3 - 48

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CH 03

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Measuring Business Income: The Adjusting Process Chapter 3

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

The Two Bases of Accounting:

Cash-basis: Transactions are recorded when cash is paid or cash is received.

2002 Prentice Hall, Inc.

Accrual Versus Cash Example

Accrual Versus Cash Example

Revenues $50 Expenses 20 Net income (loss) $30

2002 Prentice Hall, Inc.

Accrual Versus Cash Example

Cash inflows $150 Cash outflows 20 Net income (loss) $130

2002 Prentice Hall, Inc.

Managers adopt an artificial period of time to evaluate performance.

2002 Prentice Hall, Inc.

Interim Period Statements

2002 Prentice Hall, Inc.

Apply the revenue and matching principles.

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

The Matching Principle

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 11

Matching Expenses with Revenues Example

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 12

Matching Expenses with Revenues Example

2002 Prentice Hall, Inc.

The Time Period Concept

Interacts with the revenue principle and the matching principle

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

Two Types Of Adjusting Entries

2002 Prentice Hall, Inc.

Five Categories Of Adjusting Entries

Prepaid Insurance Example

Prepaid Insurance 24,000

2002 Prentice Hall, Inc.

Prepaid Insurance Example

2002 Prentice Hall, Inc.

Prepaid Insurance Example

What was the determining factor in matching this expense?

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

What was the determining factor in matching this expense?

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

Accumulated depreciation is a contra account to plant assets.

A contra accounts normal balance is opposite that of the companion account.

Wood Enterprise Example

$30,000 10,000 $20,000

2002 Prentice Hall, Inc.

Accrued Expenses Example

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 31

Accrued Expenses Example

Accrued Expenses Example

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 33

Accrued Revenues Example

2002 Prentice Hall, Inc.

Accrued Revenues Example

2002 Prentice Hall, Inc.

Accrued Revenues Example

What is the determining factor in recognizing this service revenue?