Measuring Business Income: The Adjusting Process

1. Measuring Business Income:The Adjusting Process Chapter 3

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

3. The Two Bases of Accounting: 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.

4. 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?

5. 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

6. Accrual Versus Cash Example Cash-Basis Accounting (000 omitted) 20022003 2004 Cash inflows $150 $ 0 $ 0 Cash outflows 20 20 20 Net income (loss) $130 ($20) ($20)

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

8. Interim Period Statements Monthly Quarterly Semi-annually

9. Apply the revenue andmatching principles. Objective 2

10. 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.

11. 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.

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 8,000 Net income $ 7,000

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

15. Make adjusting entries. Objective 3

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

17. Two Types OfAdjusting Entries Prepaids or Deferrals Accruals

18. Five Categories OfAdjusting Entries Prepaid expenses Accrued revenues Depreciation Unearned revenues Accruedexpenses

19. 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

20. 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

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

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

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

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

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

26. 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?

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

28. Contra Accounts 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.

29. 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

30. 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.

31. 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.

32. Accrued Expenses Example April May 1 23 2627 28 29 30

33. 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

34. 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.

35. 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

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

37. 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

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

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

40. Prepare an adjusted trial balance. Objective 4

41. 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.

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

43. Financial Statements • Financial statements have two parts: • The first part includes the following: • name of the entity • title of the statement • date or period covered • The second part is the body of the statement.

44. 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

45. 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

46. 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

47. 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

48. End of Chapter 3