Measuring Business Income: The Adjusting Process Chapter 3

cash-basis accounting. Objective 1 Distinguish accrual accounting from cash-basis accounting.

The Two Bases of Accounting: Accrual Basis Revenues are recognized when earned and expenses are recognized when incurred. Cash Basis Revenues are recognized when cash is received and expenses recorded when cash is paid. Not GAAP GAAP Accounting 9 9

Accrual Versus Cash Example In January 2009, 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)

Apply the revenue and matching principles. 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 used up and the liabilities incurred to earn revenue. Expenses are recognized when the benefit from the expense is received. The revenue principle says to record revenue when it has been earned- but not before. In most cases, revenue is earned when the business has delivered a good or service to the customer.

The Matching Principle The maching principle direct accountants to: Identify all expenses incurred during the period and measure the expenses. Match the expenses against the revenues earned during the period.

The Matching Principle To match expenses against revenue means to subtract expenses from revenues. The goal is to measure net income. Revenues 800 Expenses -700 Net Income 100 or Revenues 500 Expenses -550 Net Loss 50

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

Make adjusting entries. 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 Expenses Prepaid expenses are advance payments of expenses. Prepaid rent and prepaid insurance examples of expenses that are paid in advance. All companies, large and small, must adjust their prepaid expenses. PREPAID EXPENSES ARE ASSETS, NOT EXPENSES.

Prepaid Insurance Example On October 1, 2007, Parker Floor paid $12,000 for a one-year insurance policy. Oct. 1, 2007 Prepaid Insurance 12,000 Cash 12,000 To record insurance expense Prepaid Insurance Cash 12,000 12,000

Prepaid Insurance Example 2007 2008 October Sept 3 months 9 months 3000 9000

Prepaid Insurance Example What is the journal entry on December 31, 2007? Dec. 31, 2007 Insurance Expense 3,000 Prepaid Insurance 3,000 To record insurance expense

Prepaid Insurance Example What was the determining factor in matching this expense? Time

Supplies Example-1 Wood Enterprise started business the beginning of the month. $800 worth of office supplies were purchased on November 15, 2004, for cash.

Supplies Example-1 Office Supplies Cash 800 800 An inventory at month end indicated that $200 in office supplies remained. What is the supplies expense?

What was the determining factor in matching this expense? Supplies Example-1 Supplies Expense Supplies 800 600 Bal. 200 600 What was the determining factor in matching this expense? Usage

What is the ending balance of Supplies? Where is this item reported. Supplies Example-2 At the begining of the period, Supplies were $10.000. During the period, the company purchased $45.000 of supplies. At period’s end, $15.000 of supplies were still on hand. What was the cost of supplies used during the month? Where is this item reported. What is the ending balance of Supplies? Where is this item reported. Make the adjusting entry to update the Supplies account at the end of the period.

Supplies Example-2 Begining balance 10,000 + Purchases 45,000 Supplies avaliable 55,000 - Ending balance -15,000 Expense (supplied used) 40,000 Report supplies expense among the expenses on the Income Statement. 2. The ending balance of supplies is 15,000. On the Balance S 3. Adjusting entry: Dec. 31, 2xxx Supplies Expense 40,000 Supplies 40,000

Depreciation Accrual accounting is clearly illustrated by depreciation. Plant assets are long lived tangible assets used in the opration of a business. As the plant assets use, their usefulness declines. This decline is an expense. Accountants systematically spread the cost of plant asset over its useful life. This allocation of cost to expense is called depreciation. Land is the exception. No depreciation for land.

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 account. A contra account’s normal balance is opposite that of the companion account. Companion: either Accumulated 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 The term accrued expense refers to an expense the business has incurred but not yet paid. An accrued expense always creates a liability.

Differences between prepaid expense and accrued expenses A prepaid expense is paid first and expensed later. An accrued expense is expensed first and paid later. Prepaid and accruals are opposites.

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 Expenses Example When the business pays the weekly salary on May 3. May 3, 2002 Salaries Expense 18,000 Salaries Payable 12,000 Cash 12,000 To pay the salary

Accrued Revenues Accrued revenue, which is a revenue that has been earned but not yet collected yet.

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 Some businesses collect cash fro customer in advance. Receiving cash before earning it creates liability called unearned revenue. An unearne revenue is a liability, not a revenue.

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 liability $100,000 Total accounted for $150,000 Correct revenue $50,000

Prepaid expense&Unearned revenue Example Consider the tuition you pay your university. Assume that one semester’s tution costs $1,500 and that you make single payment up front. Can you make the journal entries to record the tution transactions on your books and on the books of your university. Your Books University’s Books Prepaid Tution 1,500 Cash 1,500 Cash 1,500 Unearned Tution 1,500 End of Semester Tution Expense 1,500 Prepaid Expense 1,500 Unearned Tution 1,500 Tution Revenue 1,500

Notice Adjusting entries always have... one income statement account and... one balance sheet account. Adjusting entries never involve cash.

Prepaid and Accrual Adjustments PREPAIDS – Cash transaction comes first First Later Prepaid Expense Pay cash and record an asset Record an expense and decrease the asset Unearned Revenues Receive and record and a liability Record a revenue and decrease the liability. ACCRUALS – Cash transaction comes later First Later Accrued Expense Accrue an expense and the related payable. Pay cash and decrease the payable. Accrued Revenues Receive and record and a liability Record a revenue and decrease the liability.

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.

adjusted trial balance. Prepare the financial statements from the adjusted trial balance.

End of Chapter 3