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.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3-2
 The Two Bases of Accounting:

Accrual-basis: Cash-basis:
Transactions are recorded Transactions are
when revenues are recorded when
earned or expenses cash is paid or
are incurred. cash is received.

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

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

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3-6
 Accounting Period

Managers adopt an
artificial period of time
to evaluate performance.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3-7
 Interim Period Statements

Monthly

Quarterly

Semi-annually

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3-8
 Objective 2

Apply the revenue and

matching principles.

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

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

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

 Matching Expenses with
Revenues Example

May

Revenues $15,000
Cost of goods sold 8,000
Net income $ 7,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 13

 The Time Period Concept

 It requires that accounting information be

reported at regular intervals.

Interacts with the Requires that income

revenue principle and be measured
the matching principle accurately each period

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 14

 Objective 3

Make adjusting entries at the

end of the accounting period.

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

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 16

 Two Types Of
Adjusting Entries

Prepaids or Deferrals

Accruals

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 17

 Five Categories Of
Adjusting Entries

Prepaid expenses Accrued revenues

Depreciation

Accrued expenses Unearned revenues

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 18

 Prepaid Insurance Example

On January 2, 2002, Parker Floor paid $24,000

for a two-year health insurance policy.

Prepaid Insurance Cash

24,000 24,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 19

 Prepaid Insurance Example

 What is the journal entry on December 31,

2002?
 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 3 - 20

 Prepaid Insurance Example

 What was the determining factor in

matching this expense?

Time

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

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 22

 Supplies Example

Office Supplies Cash

800 800

An inventory at month end indicated

that $200 in office supplies remained.
What is the supplies expense?
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 23
 Supplies Example

Supplies Expense Supplies

600 800 600
Bal. 200

What was the determining factor

Usage
in matching this expense?
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 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.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 25

 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, 2002?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 26

 Depreciation Example

Dec. 31, 2002

Depreciation Expense 10,000
Accumulated Depreciation 10,000
To record depreciation on machinery

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 27

 Contra Accounts

A contra account
has a companion A contra account’s
account. normal balance is
opposite that of
the companion
Accumulated account.
depreciation is a
contra account to
plant assets.
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 28
 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 3 - 29
 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.

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

April May

1 2 3

26 27
28 29 30
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 32
 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
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 33
 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.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 34

 Accrued Revenues Example

 What is the April 30 adjusting entry?

 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 3 - 35

 Accrued Revenues Example

 What is the determining factor in

recognizing this service revenue?

Performance

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

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

liability accounted for revenue
$100,000 $150,000 $50,000
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 38
 Notice

 Adjusting entries always have...

– one income statement account and...
– one balance sheet account.
 Adjusting entries never involve cash.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 39

 Objective 4

Prepare an adjusted
trial balance.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 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.
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 41
 Objective 5

Prepare the financial

statements from the
adjusted trial balance.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 42

 Financial Statements

 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 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
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 44
 Financial Statements Example

Prensa Insurance
Statement of Owner’s Equity
Year Ended December 31, 2002
Prensa Insurance Equity, January 1, 2002 $100,000
Add: Net income 30,000
Prensa Insurance Equity, December 31, 2002 $130,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 45

 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
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 46
 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
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 47
 End of Chapter 3

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 3 - 48