Measuring Business Income: The Adjusting Process

Distinguish accrual accounting from cash-basis accounting. Objective 1

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. The Two Bases of Accounting:

Accrual Versus Cash Example 4 In January 2002, Prensa Insurance sells a three-year health insurance policy to a business client. 4 The contract specifies that the client had to pay $150,000 in advance. 4 Yearly expenses amount to $20, What is the income or loss?

Accrual Versus Cash Example Accrual-Basis Accounting (000 omitted) Revenues$50$50$50 Expenses Net income (loss)$30$30$30

Accrual Versus Cash Example Cash-Basis Accounting (000 omitted) Cash inflows$150$ 0$ 0 Cash outflows Net income (loss)$130($20)($20)

Managers adopt an artificial period of time to evaluate performance. Accounting Period

Monthly Quarterly Semi-annually Interim Period Statements

Apply the revenue and matching principles. Objective 2

Revenue Principle 4 When is revenue recognized? 4 When it is deemed earned. 4 Recognition of revenue and cash receipts do not necessarily occur at the same time.

The Matching Principle 4 What is the matching principle? 4 It is the basis for recording expenses. 4 Expenses are the costs of assets and the increase in liabilities incurred in the earning of revenues. 4 Expenses are recognized when the benefit from the expense is received.

Matching Expenses with Revenues Example 4 Parker Floor sells a wood floor for $15,000 on the last day of May. 4 The wood was purchased from the manufacturer for $8,000 in March of the same year. 4 The floor is installed in June. 4 When is income recognized?

Revenues$15,000 Cost of goods sold 8,000 Net income$ 7,000 May Matching Expenses with Revenues Example

Interacts with the revenue principle and the matching principle Requires that income be measured accurately each period The Time Period Concept 4 It requires that accounting information be reported at regular intervals.

Make adjusting entries. Objective 3

Adjusting Entries 4 Assign revenue to the period earned. 4 Assign expenses to the period incurred. 4 Bring related asset and liability accounts into correct balance.

Prepaids or Deferrals Accruals Two Types Of Adjusting Entries

Prepaid expenses Depreciation Accrued expenses Accrued revenues Unearned revenues Five Categories Of Adjusting Entries

Types of Adjusting Entries 1.Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed. Deferrals 3. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. 2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned. Accruals LO 4 Identify the major types of adjusting entries.

Deferrals are either: Prepaid expenses OR Unearned revenues. Adjusting Entries for Deferrals LO 5 Prepare adjusting entries for deferrals.

Payment of cash, that is recorded as an asset because service or benefit will be received in the future. Adjusting Entries for “Prepaid Expenses” insurancesuppliesadvertising Cash Payment Expense Recorded BEFORE LO 5 Prepare adjusting entries for deferrals. rent maintenance on equipment fixed assets (depreciation) Prepayments often occur in

Prepaid Expenses Costs that expire either with the passage of time or through use. Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts. Adjusting Entries for “Prepaid Expenses” LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” LO 5 Prepare adjusting entries for deferrals. Adjusting entries for prepaid expenses Increases (debits) an expense account and Decreases (credits) an asset account. Illustration 3-4

Example (Insurance): On Jan. 1 st, Phoenix Consulting paid $12,000 for 12 months of insurance coverage. Show the journal entry to record the payment on Jan. 1 st. Cash 12,000 Prepaid Insurance12,000 Jan. 1 DebitCredit Prepaid Insurance 12,00012,000 DebitCredit Cash Adjusting Entries for “Prepaid Expenses” LO 5 Prepare adjusting entries for deferrals.

Example (Insurance): On Jan. 1 st, Phoenix Consulting paid $12,000 for 12 months of insurance coverage. Show the adjusting journal entry required at Jan. 31 st. Prepaid Insurance1,000 Insurance Expense1,000Jan. 31 DebitCredit Prepaid Insurance 12,0001,000 DebitCredit Insurance Expense 1,000 11,000 Adjusting Entries for “Prepaid Expenses” LO 5 Prepare adjusting entries for deferrals.

24,000 CashPrepaid Insurance 24,000 Prepaid Insurance Example On January 2, 2005, Parker Floor paid $24,000 for a two-year health insurance policy. On January 2, 2005, Parker Floor paid $24,000 for a two-year health insurance policy.

Prepaid Insurance Example 4 What is the journal entry on December 31, 2005? 4 Dec. 31, 2005 Insurance Expense 12,000 Prepaid Insurance 12,000 To record insurance expense

Time Prepaid Insurance Example 4 What was the determining factor in matching this expense?

Accruals 4 What is an accrual? 4 It is the recognition of an expense or revenue that has arisen but has not yet been recorded. 4 Expenses or revenues are recorded before the cash settlement.

Accrued Expenses Example 4 Employees at Mary Business Services are paid every Friday. 4 Weekly salaries total $30, The business is closed on Saturday and Sunday. 4 The employees were last paid on April 26, which was a Friday. 4 They will be paid on May 3.

April May Accrued Expenses Example

4 What is the adjusting entry on April 30? 4 They worked April 29 and $30,000 ÷ 5 = $6,000 per day 4 $6,000 × 2 days = $12,000 4 April 30, 2002 Salaries Expense 12,000 Accrued Salaries Expenses 12,000 To accrue salary expense

Accrued Revenues Example 4 During the month of April, Mary Business Services rendered services to customers totaling $15, At the end of April, the customers have not as yet been billed.

Accrued Revenues Example 4 What is the April 30 adjusting entry? 4 April 30, 2005 Accrued service Receivable 15,000 Service Revenue 15,000 To accrue service revenue

Performance Accrued Revenues Example 4 What is the determining factor in recognizing this service revenue?

Unearned or Deferred Revenue Example 4 In January 2005, Prensa Insurance received $150,000 from a business client to provide health insurance coverage for three years. 4 January 2, 2005 Cash 150,000 Unearned Revenue 150,000 Received revenue in advance

Correct liability $100,000 Total accounted for $150,000 Correct revenue $50,000 Unearned or Deferred Revenue Example 4 What is the journal entry on December 31, 2005? 4 Unearned revenue 50,000 Revenue 50,000 To record revenue collected in advance

Notice 4 Adjusting entries always have... – one income statement account and... – one balance sheet account. 4 Adjusting entries never involve cash.

Prepare an adjusted trial balance. Objective 4

Adjusted Trial Balance 4 The adjusting process starts with the unadjusted trial balance. 4 Adjusting entries are made at the end of the accounting period and then an adjusted trial balance is prepared. 4 The adjusted trial balance serves as the basis for the preparation of the financial statements.

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 plant assets. Contra Accounts

Wood Enterprise Example Partial Balance Sheet December 31, 2005 Plant assets: Machinery$30,000 Less: Accumulated depreciation 10,000 Total$20,000 Plant assets: Machinery$30,000 Less: Accumulated depreciation 10,000 Total$20,000 Contra account Book value

Buildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired. Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life (Matching Principle). Adjusting Entries for “ ” Adjusting Entries for “ Depreciation ” LO 5 Prepare adjusting entries for deferrals.

Example (Depreciation): On Jan. 1 st, Phoenix Consulting paid $24,000 for equipment that has an estimated useful life of 20 years. Show the journal entry to record the purchase of the equipment on Jan. 1 st. Cash24,000 Equipment 24,000 Jan. 1 DebitCredit Equipment 24,00024,000 DebitCredit Cash Adjusting Entries for “ Depreciation ” LO 5 Prepare adjusting entries for deferrals.

Example (Depreciation): On Jan. 1 st, Phoenix Consulting paid $24,000 for equipment that has an estimated useful life of 20 years. Show the adjusting journal entry required at Jan. 31 st. ($24,000 / 20 yrs. / 12 months = $100) Accumulated Depreciation100 Depreciation Expense 100 Jan. 31 DebitCredit Depreciation Expense DebitCredit Accumulated Depreciation Adjusting Entries for “ Depreciation ” LO 5 Prepare adjusting entries for deferrals.

Depreciation (Statement Presentation) Accumulated Depreciation is a contra asset account. Appears just after the account it offsets (Equipment) on the balance sheet. Adjusting Entries for “” Adjusting Entries for “ Depreciation ” LO 5 Prepare adjusting entries for deferrals.

Depreciation Example 4 On January 2, Wood Enterprise purchased a truck for $30,000 cash. 4 The truck is expected to last for 3 years.

Depreciation Example 4 The cost of the truck must be matched with the accounting periods in which it was used to earn income. 4 What is the journal entry for the year ended December 31, 2005?

Dec. 31, 2005 Depreciation Expense 10,000 Accumulated Depreciation 10,000 To record depreciation on truck Depreciation Example

Prepare the financial statements from the adjusted trial balance. Objective 5

Financial Statements 4 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 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 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 Income Statement 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 Statement of Owner’s Equity Year Ended December 31, 2005

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 Prensa Insurance Balance Sheet Year Ended December 31, 2002

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 Financial Statements Example

Trial Balance Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date. Trial Balance LO 4 Identify the major types of adjusting entries.

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