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Chapter 3 - The Adjusting Process
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.
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Chapter 3 - The Adjusting Process
- 1. Measuring Business Income: The AdjustingProcess Chapter 3
- 2. Objective 1 Distinguish accrual accountingfrom cash-basis accounting.
- 3. The Two Basesof 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 CashExample 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 CashExample 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 CashExample 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 adoptan artificial period of time to evaluate performance.
- 8.
- 9. Objective 2 Apply therevenue and matching principles.
- 10. Revenue Principle When isrevenue recognized? When it is deemed earned. Recognition of revenue and cash receipts do not necessarily occur at the same time.
- 11. The Matching Principle Whatis 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 RevenuesExample 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 RevenuesExample May Revenues Cost of goods sold Net income $15,000 8,000 $ 7,000
- 14. The Time PeriodConcept 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.
- 16. Adjusting Entries Assign revenueto the period earned. Assign expenses to the period incurred. Bring related asset and liability accounts into correct balance.
- 17. Two Types Of AdjustingEntries Prepaids or Deferrals Accruals
- 18. Five Categories Of AdjustingEntries Prepaid expenses Accrued revenues Depreciation Accrued expenses Unearned revenues
- 19. Prepaid Insurance Example OnJanuary 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 Whatis 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 Whatwas the determining factor in matching this expense? Time
- 22. Supplies Example Wood Enterprisestarted 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 Aninventory at month end indicated that $200 in office supplies remained. What is the supplies expense?
- 24. Supplies Example Supplies Expense 600 Supplies 800600 Bal. 200 What was the determining factor in matching this expense? Usage
- 25. Depreciation Example On January2, Wood Enterprise purchased a truck for $30,000 cash. The truck is expected to last for 3 years.
- 26. Depreciation Example The costof 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 contraaccount 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 PartialBalance 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 anaccrual? 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 Employeesat 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 12 3 26 27 28 29 30
- 33. Accrued Expenses Example Whatis 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 Duringthe 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 Whatis the April 30 adjusting entry? April 30, 2005 Accounts Receivable 15,000 Service Revenue 15,000 To accrue service revenue
- 36. Accrued Revenues Example Whatis the determining factor in recognizing this service revenue? Performance
- 37. Unearned or DeferredRevenue 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 DeferredRevenue 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 alwayshave... – one income statement account and... – one balance sheet account. Adjusting entries never involve cash.
- 40.
- 41. Adjusted Trial Balance Theadjusting 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 thefinancial statements from the adjusted trial balance.
- 43. Financial Statements 1 – – – 2 Financial statementshave 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 PrensaInsurance 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 PrensaInsurance 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 PrensaInsurance 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 Liabilitiesand 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.
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