This document discusses accrual versus cash basis accounting and the adjusting process. It begins by distinguishing between accrual accounting, where transactions are recorded when revenues are earned or expenses incurred, and cash basis accounting, where transactions are recorded when cash is paid or received. The key aspects of the adjusting process covered are: applying the revenue and matching principles, making adjusting entries for prepaid, accrued, and deferred items, preparing an adjusted trial balance, and using that to make the final financial statements. The overall goal is to ensure revenues and expenses are recorded in the appropriate accounting period.

1. Measuring Business
Income:
The Adjusting Process
Chapter 3

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

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
Revenues
$50
Expenses
20
Net income (loss) $30
2003
2004
$50
20
$30
$50
20
$30

6. Accrual Versus Cash Example
Cash-Basis Accounting
(000 omitted)
2002
Cash inflows
$150
Cash outflows
20
Net income (loss) $130
2003
2004
$ 0
20
($20)
$ 0
20
($20)

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

8. Interim Period Statements
Monthly
Quarterly
Semi-annually

9. Objective 2
Apply the revenue
and
matching principles.

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
Cost of goods sold
Net income
$15,000
8,000
$ 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. Objective 3
Make adjusting
entries.

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 Of
Adjusting Entries
Prepaids or Deferrals
Accruals

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

19. Prepaid Insurance Example
On January 2, 2005, Parker Floor paid
$24,000
for a two-year health insurance policy.
Prepaid Insurance
24,000
Cash
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
800
Cash
800
An inventory at month end indicated
that $200 in office supplies remained.
What is the supplies expense?

24. Supplies Example
Supplies Expense
600
Supplies
800 600
Bal. 200
What was the determining factor
in matching this expense?
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. Depreciation Example
Dec. 31, 2005
Depreciation Expense
10,000
Accumulated Depreciation
10,000
To record depreciation on truck

28. Contra Accounts
A contra account
has a companion
account.
Accumulated
depreciation is a
contra account to
plant assets.
A contra account’s
normal balance is
opposite that of
the companion
account.

29. Wood Enterprise Example
Partial Balance Sheet
December 31, 2005
Plant assets:
Machinery
Less: Accumulated depreciation
Total
$30,000
10,000
$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 2 3
26 27
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
Correct
liability
$100,000
Total
accounted for
$150,000
Correct
revenue
$50,000

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

40. Objective 4
Prepare an
adjusted
trial balance.

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

43. Financial Statements
1
–
–
–
2
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
Add: Net income
Prensa Insurance Equity, December 31, 2002
$100,000
30,000
$130,000

46. Financial Statements Example
Prensa Insurance
Balance Sheet
Year Ended December 31, 2002
Assets:
Cash
Accounts receivable
Supplies inventory
Prepaid rent
Office equipment
Less: Accumulated depreciation
Total assets
$189,150
5,000
100
1,000
5,000
250
$200,000

47. Financial Statements Example
Liabilities and Equities:
Utilities payable
Interest payable
Accounts payable (supplies)
Salaries payable
Bank loan
Total liabilities
Owner’s equity
Total liabilities and owner’s equity
$
150
600
250
4,100
64,900
$ 70,000
130,000
$200,000

48. End of Chapter 3