Measuring Business Income:
The Adjusting Process
Chapter 3
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1
Objective 1
Distinguish accrual accounting from cashbasis accounting
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Accrual Basis Vs. Cash Basis
Accrual Basis
Cash Basis
Revenues are
recognized when
earned and expenses
are recognized when
incurred.
Revenues are
recognized when
cash is received and
expenses recorded
when cash is paid.
Not GAAP
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3
S3-1
•
Service revenue:
(a) Cash basis
(b) Accrual basis (600+500)
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$600
$1,100
4
Accounting Period
• Managers adopt an artificial period of time
to evaluate performance
– Monthly
– Quarterly
– Semiannually
– Annually
Interim Statements
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Objective 2
Apply the revenue and matching principles
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Recognizing Revenues and
Expenses
Three new basic accounting principles
• Revenue Recognition
• Matching
• Time Period
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Revenue Principle
• When is revenue recognized?
– When it is earned
– Not necessarily when cash is received
• How much revenue should be recognized?
– Cash value of item transferred to customer
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S3-3
a. When should revenue be recorded?
When the magazines are mailed to
customers
b. How much revenue should be recorded?
As of March, three month’s revenue
should be recognized
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The Matching Principle
• Measure all expenses incurred during the
accounting period
• When are expenses recognized?
– Match the expenses against the revenues
earned during the period
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Adjusting Entries
• At the end of an accounting period, ask
yourself these questions:
– Have I recorded all revenues earned during
this accounting period?
– Have I recognized all expenses incurred
during this accounting period?
• If the answer is “No”, you need to prepare
an adjusting entry
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Prepaid rent is an asset –
this will benefit the company
in the future. Since you
have not occupied the
apartment yet, it is not an
expense yet
S3-4
Jan 1 – Paid rent for the entire year.
GENERAL JOURNAL
DATE
DESCRIPTION
REF
Jan 1 Prepaid Rent
Cash
Prepaid rent for 1 year
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DEBIT
CREDIT
3,600
3,600
12
Each month, we’ll recognize
S3-4
rent expense; and each
Prepaid Rent
Jan 1
3,600 300
300
300
300
300
300
300
300
300
Bal 900
Jan 31
Feb 28
Mar 31
Apr 30
May 31
Jun 30
Jul 31
Aug 31
Sep 30
month, we’ll reduce the
Rentuntil
Expense
prepaid account
the
year is
over.
300
300
300
300
300
300
300
300
300
Bal 2,700
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The Time Period Concept
• Requires that accounting information
be reported at regular intervals
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Objective 3
Make adjusting entries
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Adjusting Entries
• Prepared at end of an accounting period
• Recorded to bring an asset or liability
account balance to its proper amount
– Recognize all revenues when earned
– Recognize all expenses incurred
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Adjusting Entries
At the end of an accounting period, ask
yourself these questions:
• Have I recognized all revenues earned this
period?
• Have I recorded all expenses incurred this
period?
If the answer is “No”, you need to prepare
an adjusting entry
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17
Thomas Consulting Service, Inc.
Trial Balance
June 30, 2009
ACCOUNT
Cash
Accounts receivable
Office supplies
Office furniture
Building
Accounts payable
Unearned service revenue
Common stock
Retained earnings
Service revenue
Salary expense
Rent expense
Advertising expense
Utilities expense
Total
DEBIT
CREDIT
$ 8,000
4,000
2,000
18,000
50,000
$ 30,000
3,000
40,000
6,800
7,000
3,000
800
600
400
$86,800
$86,800
Adjusting Entries
Five categories
• Prepaid expenses
• Depreciation
• Accrued revenues
• Accrued expenses
• Unearned revenues
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Adjusting Prepaid Expenses
Resources paid for prior to receiving the actual
benefits.
Prepaid Asset
Used up portion =
Expense
Unused portion =
Prepaid
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S 3-5
GENERAL JOURNAL
DATE
Apr
DESCRIPTION
REF
1 Prepaid Rent
Cash
Prepaid rent for 6 months
DEBIT
CREDIT
3,000
3,000
Prepaid Rent
4/1
3,000
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S 3-5
GENERAL JOURNAL
DATE
DESCRIPTION
REF
Rent is $500
per month
($3,000/6).
DEBIT
Apr 30 Rent Expense
Prepaid Rent
To record rent for April
Prepaid Rent
4/1
Bal
3,000 4/30
CREDIT
500
500
Rent Expense
500
4/30
500
2,500
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Long term
Adjusting for Depreciation
plant assets
except for
land are
allocating
depreciated.
Depreciation - process of
the cost of a plant asset to expense
over its expected useful life
Straight-Line
=
Depreciation Expense
Asset Cost
Useful Life
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S 3-6
GENERAL JOURNAL
DATE
DESCRIPTION
REF
May 1 Computer Equipment
Cash
Purchased computer
DEBIT
CREDIT
36,000
36,000
Computer Equipment
5/1
36,000
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Depreciation
• Depreciation, for accounting purposes, is not an
attempt to assign a market value to assets
• It is merely a systematic way of allocating some
of the cost of the asset to each period that asset
helps the company earn revenue
• Accumulated Depreciation
– A contra asset account
– Represents the amount of depreciation that has been
taken over the life of the asset to date
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S 3-6
GENERAL JOURNAL
DATE
DESCRIPTION
May 31 Depreciation Expense,
Computer Equipment
Income
Statement
REF
DEBIT
CREDIT
Account
1,000
Accumulated Depreciation,
Computer Equipment
1,000
To record depreciation for May
Balance Sheet Account
Accumulated depreciation is
a contra asset account.
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S 3-6
Computer Equipment
5/1
36,000
Accumulated Depreciation,
Computer Equipment
5/31 1,000
Bal
1,000
Depreciation Expense,
Computer Equipment
5/31 1,000
Bal
1,000
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Book Value
Reported on balance sheet
Cost minus accumulated depreciation
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S 3-6
Your Company
Balance Sheet
May 31, 20XX
Assets
Cash
.
.
.
Computer Equipment
Less: Accumulated Depreciation
Total Assets
$XXXX
$ 36,000
(1,000) 35,000
$XXXX
Book Value
Notice: accumulated
depreciation increases
each accounting
period. The book
Your Companyvalue gradually gets
smaller.
Balance Sheet
S 3-6
June 30, 20XX
Assets
Cash
.
.
.
Computer Equipment
Less: Accumulated Depreciation
Total Assets
$XXXX
$ 36,000
(2,000) 34,000
$XXXX
Book Value
Accrued Expenses
Costs incurred in a period that are both
unpaid and unrecorded
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S 3-8
GENERAL JOURNAL
DATE
DESCRIPTION
REF
Dec 31 Interest Expense
Interest Payable
To record accrued interest
DEBIT
CREDIT
700
700
When you borrow money, interest
Interest Expenseexpense is accumulating
Interest
Payable
everyday.
At the end of an accounting period,
12/31 700
700 12/31
you need to figure out how much
interest has accrued and recognize
the expense. You also have to
recognize that you must pay that
money sometime in the future.
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Accrued Revenues
Revenues earned in a period that are
both unrecorded and not yet received
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Accrued Revenues
• Your lawn maintenance company agrees to
provide 30 hours of work at $60 per hour for
Company A. It is also agreed that you will bill
them when the work had been completed.
• As of May 31, you have worked 20 hours on this
contract. The 20 hours’ worth of revenues
earned in May, must be recorded in May, even
though you haven’t billed your customer yet.
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Accrued Revenues
How much revenue
was earned in May?
$60 x 20 = $1200
GENERAL JOURNAL
DATE
DESCRIPTION
REF
May 31 Accounts Receivable
Service Revenue
To record accrued revenues
Accounts Receivable
5/31
DEBIT
CREDIT
1,200
1,200
Service Revenue
1,200
1,200 5/31
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Unearned Revenue
Cash received in advance of providing
products or services
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When the money is
S 3-9 received,
the company
DATE
Dec 31
debits cash and credits
GENERAL JOURNAL
Unearned Revenue (a
REFrecognizing
DESCRIPTION
DEBIT that
CREDIT
liability
the company owes their
Unearned Subscription
customer a service or
product).
Revenue
5,000
Subscription Revenue
To record revenue earned
5,000
At the end of an
accounting period, you
must determine how
much of that unearned
revenue has actually
been earned.
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Tips
• An adjusting entry will NEVER involve a
debit or credit to Cash
• Each adjusting entry will affect at least one
balance sheet account and one income
statement account
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Summary
Prepaid expenses
Depreciation
Debit Expense
Credit Asset (Prepaid)
Debit Depreciation Expense
Credit Accumulated Depreciation
Accrued revenues
Debit Receivable
Credit Revenue
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Summary
Accrued expenses
Unearned revenues
Debit Expense
Credit Liability
Debit Liability (Unearned)
Credit Revenue
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is an example of
E3-19 This
a.
unearned revenues:
$4,000 /12 = $333.33
GENERAL JOURNAL
DATE
DESCRIPTION
Dec 31 Unearned Rent Revenue
per month
REFhaveDEBIT
3 months
expired.
$333.33 x 3 = $1,000
CREDIT
1,000
Rent Revenue
1,000
To record revenue earned
Unearned Rent Revenue
10/1 4,000
12/31
1,000
Bal. 3,000
Rent Revenue
12/31
1,000
This is an example of
accrued expenses.
The company owes
employees salaries for
GENERAL JOURNAL
two days’ work –
Monday REF
and Tuesday.
DESCRIPTION
DEBIT
E3-19 b.
DATE
Dec 31 Salary Expense
Salary Payable
To record accrued salaries
Salaries Expense
12/31
3,000
CREDIT
3,000
3,000
Salaries Payable
12/31
3,000
How much of the supplies
have been used up? We
stared with $3,100 and
ended up with $1,200. The
GENERAL JOURNAL
rest was used up.
E3-19 c.
DATE
REF
DESCRIPTION
DEBIT
Dec 31 Supplies Expense
Supplies
To record supplies used
Supplies
3,100
12/31 1,900
Bal.
1,200
CREDIT
1,900
1,900
Supplies Expense
12/31 1,900
E3-19 d.
GENERAL JOURNAL
DATE
REF
DESCRIPTION
Dec 31 Depreciation Expense,
Equipment
Accumulated Depreciation,
Equipment
To record depreciation
Accumulated Depreciation
12/31
2,500
DEBIT
CREDIT
2,500
2,500
Depreciation Expense
12/31
2,500
E3-19 f.
GENERAL JOURNAL
DATE
REF
DESCRIPTION
Dec 31 Insurance Expense
Prepaid Insurance
To record insurance expired
Prepaid Insurance
Bal
1,200
Bal. 1,000
200
CREDIT
200
200
Insurance Expense
12/31
12/31
DEBIT
200
Objective 4
Prepare an adjusted trial balance
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Scissors Hair Stylists, Inc.
Worksheet
December 31, 2005
S 3-10
Trial Balance
Account Title
Cash
Supplies
Equipment
Accum. depr. - Equip.
Accounts payable
Interest payable
Note payable
Common stock
Service revenue
Rent expense
Supplies expense
Depreciation expense
Interest expense
Totals
Dr.
400
700
17,000
Cr.
Adjustments
Dr.
Cr.
a. 500
1,000
200
Adjusted
Trial Balance
Dr.
400
200
17,000
2,000
200
100
3,000
6,000
12,000
b. 1,000
c. 100
3,000
6,000
12,000
4,000
100
22,200
22,200
a. 500
b. 1,000
c. 100
1,600
1,600
Cr.
4,000
500
1,000
200
23,300
23,300
Scissors Hair Stylists, Inc.
Worksheet
December 31, 2005
Adjusted
Trial Balance
Account Title
Dr.
Cr.
Cash
400
200
Supplies
Equipment
17,000
Accum. depr. - Equip.
2,000
Accounts payable
200
Interest payable
100
Note payable
3,000
Common stock
6,000
Service revenue
12,000
Rent expense
4,000
Supplies expense
500
Depreciation expense
1,000
Interest expense
200
Totals
23,300 23,300
S 3-11
Net Income $6,300
Scissors Hair Stylists, Inc.
Worksheet
December 31, 2005
Adjusted
Trial Balance
Account Title
Dr.
Cr.
Cash
400
200
Supplies
Equipment
17,000
Accum. depr. - Equip.
2,000
Accounts payable
200
Interest payable
100
Note payable
3,000
Common stock
6,000
Service revenue
12,000
Rent expense
4,000
Supplies expense
500
Depreciation expense
1,000
Interest expense
200
Totals
23,300 23,300
S 3-12
Total Assets =
$15,600
Objective 5
Prepare the financial statements
from the adjusted trial balance
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Scissors Hair Stylists, Inc.
Worksheet
December 31, 2005
Adjusted
Trial Balance
Account Title
Dr.
Cr.
400
Cash
200
Supplies
Equipment
17,000
Accum. depr. - Equip.
2,000
Accounts payable
200
Interest payable
100
Note payable
3,000
Common stock
6,000
Service revenue
12,000
Rent expense
4,000
Supplies expense
500
Depreciation expense
1,000
200
Interest expense
Totals
23,300 23,300
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Balance Sheet
Accounts
Income Statement
Accounts
51
Scissors Hair Stylists, Inc.
Income Statement
Scissors Hair Stylists, Inc.
For the Year Ended December 31, 2005
Worksheet
December 31,Service
2005 revenue
$12,000
Adjusted
Expenses:
Trial Balance
Account Title
Dr. expense
Cr.
Rent
$ 4,000
400
Cash
Supplies expense
500
200
Supplies
Depreciation expense
1,000
Equipment
17,000
Accum. depr. - Equip.
Interest 2,000
expense
200
Accounts payable
200
Total Expenses
5,700
Interest payable
100
Net Income
$ 6,300
Note payable
3,000
Common stock
6,000
Service revenue
12,000
Rent expense
4,000
Supplies expense
500
Income Statement
Depreciation expense
1,000
Accounts
200
Interest expense
Totals
23,300 23,300
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Scissors Hair Stylists, Inc.
Worksheet
Scissors Hair Stylists, Inc.
December 31, 2005
Statement of Retained Earnings
Adjusted
Trial Balance
For the Year Ended December 31, 2005
Account Title
Dr.
Cr.
Retained earnings, Jan. 1, 2005
$0
Cash
400
Supplies
200 Add: Net Income
6,300
Equipment
17,000 Retained earnings, Dec. 31, 2005
$6,300
Accum. depr. - Equip.
2,000
Accounts payable
200
Interest payable
100
Note payable
3,000
Common stock
6,000
Service revenue
12,000
Rent expense
4,000
Supplies expense
500
1,000
Depreciation expense
200
Interest expense
Totals
23,300 23,300
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Scissors Hair Stylists, Inc.
Worksheet
December 31, 2005
Scissors Hair Stylists, Inc.
Adjusted Balance
Trial Balance
December 31, 2005
Account Title
Dr.
Cr.
Assets
Liabilities
400
Cash
200
Cash
$ 400
Accounts payable
Supplies
17,000
Equipment
Supplies
200
Interest payable
2,000
Balance Sheet
Accum. depr. - Equip.
Equipment
$17,000
Note payable
200
Accounts
payable
Accounts
Total
Liabilities
Less:
100
Interest payable
3,000
NoteAccumulated
payable
Stockholder’s Equity
Depreciation
2,000 6,000
15,000
Common
stock
12,000
Service revenue
Common stock
4,000
Rent expense
Retained earnings
500
Supplies expense
Total stockholder’
1,000
Depreciation expense
equity
200
Interest expense
Total liabilities &
23,300 23,300
Totals
Total Assets
$15,600
stockholders’ equity
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$
200
100
3,000
$ 3,300
$6,000
6,300
$12,300
$ 15,600
54
End of Chapter 3
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55