1. Measuring Business Income: The Adjusting Process
Chapter 3

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

3. 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

4. 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?

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

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

7. Apply the revenue and matching principles.
Objective 2
Apply the revenue and matching principles.

8. 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.

9. 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.

10. 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.

11. 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

12. 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?

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

14. Make adjusting entries.
Objective 3
Make adjusting entries.

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

16. Two Types Of Adjusting Entries
Prepaids or Deferrals
Accruals

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

18. 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.

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

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

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

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

23. 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.

24. 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?

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

26. What is the ending balance of Supplies? Where is this item reported.
Supplies Example-2
At the begining of the period, Supplies were $
During the period, the company purchased $ of supplies.
At period’s end, $ 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.

27. Supplies Example-2 Begining balance 10,000 + Purchases 45,000
Supplies avaliable 55,000
- Ending balance ,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

28. 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.

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

30. 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?

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

32. 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.

33. 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

34. 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.

35. 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.

36. 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.

37. 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.

38. Accrued Expenses Example
April
May
26 27

39. 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, Salaries Expense , Salaries Payable , To accrue salary expense

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

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

42. 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.

43. Accrued Revenues Example
What is the April 30 adjusting entry?
April 30, Accounts Receivable , Service Revenue ,000 To accrue service revenue

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

45. 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.

46. 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, Cash , Unearned Revenue 150, Received revenue in advance

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

48. 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 ,500
Cash ,500
Cash ,500
Unearned Tution ,500
End of Semester
Tution Expense ,500
Prepaid Expense ,500
Unearned Tution ,500
Tution Revenue ,500

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

50. 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.

51. Objective 4
Prepare an adjusted
trial balance.

52. 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.

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

54. End of Chapter 3