Measuring Business Profit: The Adjusting Process Chapter 3 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

3 - 2 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Objectives 1. Distinguish accrual-basis accounting from cash-basis accounting. 2. Make adjusting entries at the end of the accounting period. 3. Prepare an adjusted trial balance. 4. Prepare the financial statements from the adjusted trial balance.

3 - 3 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Distinguish accrual-basis accounting from cash-basis accounting. Objective 1

3 - 4 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrual-basis: Transactions are recorded when revenues are earned or expenses are incurred. 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. Cash-basis: Transactions are recorded when cash is paid or cash is received. The Two Bases of Accounting:

3 - 5 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrual Versus Cash Example l In January 2004, Prensa Insurance sells a three-year health insurance policy to a business client. l The contract specifies that the client had to pay $150,000 in advance. l Yearly expenses amount to $20,000. l What is the profit or loss?

3 - 6 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrual Versus Cash Example Accrual-Basis Accounting (000 omitted) Revenues$50$50$50 Expenses Net profit (loss) $30$30$30

3 - 7 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrual Versus Cash Example Cash-Basis Accounting (000 omitted) Cash inflows$150$ 0$ 0 Cash outflows Net profit (loss) $130($20)($20)

3 - 8 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Managers adopt an artificial period of time to evaluate performance. Managers adopt an artificial period of time to evaluate performance. Accounting Period

3 - 9 Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Monthly Quarterly Half-yearly Interim Period Statements

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Revenue Principle l When is revenue recognised? l When it is deemed earned. l Recognition of revenue and cash receipts do not necessarily occur at the same time.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia The Matching Principle l What is the matching principle? l It is the basis for recording expenses. l Expenses are the costs of assets and the increase in liabilities incurred in the earning of revenues. l Expenses are recognised when the benefit from the expense is received.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Matching Expenses with Revenues Example l Parker Floor sells a wood floor for $15,000 on the last day of May. l The wood was purchased from the manufacturer for $8,000 in March of the same year. l The floor is installed in June. l When is profit recognised?

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Revenues$15,000 Cost of goods sold 8,000 Net profit $ 7,000 May Matching Expenses with Revenues Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Interacts with the revenue principle and the matching principle Requires that profit be measured accurately each period The Time Period Concept l It requires that accounting information be reported at regular intervals.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Make adjusting entries at the end of the accounting period. Objective 2

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Adjusting Entries l Assign revenue to the period earned. l Assign expenses to the period incurred. l Bring related asset and liability accounts into correct balance.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Prepaids or Deferrals Accruals Two Types Of Adjusting Entries

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Prepaid expenses Depreciation Accrued expenses Accrued revenues Unearned revenues Five Categories Of Adjusting Entries

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia 36,000 CashPrepaid Insurance 36,000 Prepaid Insurance Example On July 2, 2004, Tsai Tools paid $36,000 for a three-year health insurance policy.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Prepaid Insurance Example l What is the journal entry on June 30, 2005? l Insurance Expense 12,000 Prepaid Insurance 12,000 To record insurance expense

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Time Prepaid Insurance Example l What was the determining factor in matching this expense?

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Supplies Example l Elderly Enterprise started business at the beginning of the month. l $800 worth of office supplies were purchased on November 15, 2004, for cash.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Office SuppliesCash 800 An inventory at month end indicated that $200 in office supplies remained. What is the supplies expense? Supplies Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Usage Supplies Expense 600 Supplies Bal. 200 Supplies Example What was the determining factor in matching this expense?

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Depreciation Example l On July 1, 2003 Ahmed Arbourists purchased a truck for $30,000 cash. l The truck is expected to last for 3 years.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Depreciation Example l The cost of the truck must be matched with the accounting periods in which it was used to earn revenue. l What is the journal entry for the year ended June 30, 2004? l Depreciation Expense 10,000 Accumulated Depreciation 10,000 To record depreciation on truck

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia A contra account has a companion account. A contra account’s normal balance is opposite that of the companion account. Accumulated depreciation is a contra account to truck assets. Accumulated depreciation is a contra account to truck assets. Contra Accounts

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Ahmed Arbourists Example Partial Balance Sheet June 30, 2004 Plant assets: Machinery$30,000 Less: Accumulated depreciation 10,000 Total$20,000 Contra account Book value

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accruals l What is an accrual? l It is the recognition of an expense or revenue that has arisen but has not yet been recorded. l Expenses or revenues are recorded before the cash settlement.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrued Expenses Example l Employees at Mary Business Services are paid every Friday. l Weekly salaries total $30,000. l The business is closed on Saturday and Sunday. l The employees were last paid on April 26, which was a Friday. l They will be paid again on May 3.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia April May Accrued Expenses Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrued Expenses Example l What is the adjusting entry on April 30? l They worked April 29 and 30. l $30,000 ÷ 5 = $6,000 per day l $6,000 × 2 days = $12,000 l April 30, 2004 Salaries Expense 12,000 Salaries Payable 12,000 To accrue salary expense

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrued Revenues Example l During the month of April, Mary Business Services rendered services to customers totaling $15,000. l At the end of April, the customers have not as yet been billed.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Accrued Revenues Example l What is the April 30 adjusting entry? l April 30, 2004 Accounts Receivable 15,000 Service Revenue 15,000 To accrue service revenue

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Performance Accrued Revenues Example l What is the determining factor in recognising this service revenue?

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Unearned or Deferred Revenue Example l In January 2004, Prensa Insurance received $150,000 from a business client to provide health insurance coverage for three years. l January 2, 2004 Cash 150,000 Unearned Revenue 150,000 Received revenue in advance

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Correct liability $100,000 Correct liability $100,000 Total accounted for $150,000 Total accounted for $150,000 Correct revenue $50,000 Correct revenue $50,000 Unearned or Deferred Revenue Example l What is the journal entry on December 31, 2004? Unearned revenue 50,000 Revenue 50,000 To record revenue collected in advance

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Notice l Adjusting entries always have... – one statement of financial performance account and... – one statement of financial position account. never l Adjusting entries never involve cash.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Prepare an adjusted trial balance. Objective 4

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Adjusted Trial Balance l The adjusting process starts with the unadjusted trial balance. l Adjusting entries are made at the end of the accounting period and then an adjusted trial balance is prepared. l The adjusted trial balance serves as the basis for the preparation of the financial statements. l See exhibit 3.8 page 106 of your textbook

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Prepare the financial statements from the adjusted trial balance. Objective 5

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Financial Statements l 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.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Financial Statements Example 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 profit$30,000 Prensa Insurance Statement of financial performance Year Ended December 31, 2004

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Prensa Insurance Equity, January 1, 2004$100,000 Add: Net profit 30,000 Prensa Insurance Equity, December 31, 2004$130,000 Financial Statements Example Prensa Insurance Statement of Owner’s Equity Year Ended December 31, 2004

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Assets: Cash $189,150 Accounts receivable 5,000 Supplies 100 Prepaid rent 1,000 Office equipment 5,000 Less: Accumulated depreciation 250 4,750 Total assets $200,000 Financial Statements Example Prensa Insurance Statement of Financial Position As At December 31, 2004

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Liabilities: Electricity payable$ 150 Interest payable 600 Accounts payable (supplies) 250 Salaries payable 4,100 Bank loan 64,900 Total liabilities$ 70,000 Total Owner’s equity 130,000 Total liabilities and owner’s equity$200,000 Financial Statements Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia End of Chapter 3