Measuring Business Income:

The Adjusting Process

Chapter 3
Objective 1

Distinguish accrual
accounting from
cash-basis accounting.
The Two Bases of Accounting:

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

revenue principle and be measured
the matching principle accurately each period
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?
 Supplies Example

Supplies Expense Supplies

600 800 600
Bal. 200

What was the determining factor

Usage
in matching this expense?
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 A contra account’s
account. normal balance is
opposite that of
the companion
Accumulated account.
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 Total Correct

liability accounted for revenue
$100,000 $150,000 $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.
Objective 5

Prepare the financial

statements from the
adjusted trial balance.
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.
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