Measuring Business Income:
The Adjusting Process
Objective 1
Distinguish accrual
accounting from
cash-basis accounting.
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.
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?
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
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)
Accounting Period
Managers adopt an
artificial period of time
to evaluate performance.
Interim Period Statements
Monthly
Quarterly
Semi-annually
Objective 2
Apply the revenue and
matching principles.
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.
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.
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?
Matching Expenses with
Revenues Example
May
Revenues
Cost of goods sold
Net income
$15,000
8,000
$ 7,000
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
Objective 3
Make adjusting entries.
Adjusting Entries
 Assign revenue to the period earned.
 Assign expenses to the period incurred.
 Bring related asset and liability accounts
into correct balance.
Two Types Of
Adjusting Entries
Prepaids or Deferrals
Accruals
Five Categories Of
Adjusting Entries
Prepaid expenses
Accrued revenues
Depreciation
Accrued expenses
Unearned revenues
Types of Adjusting Entries
Deferrals
Accruals
1. Prepaid Expenses.
Expenses paid in cash and
recorded as assets before
they are used or consumed.
3. Accrued Revenues.
Revenues earned but not
yet received in cash or
recorded.
2. Unearned Revenues.
Revenues received in cash
and recorded as liabilities
before they are earned.
4. Accrued Expenses.
Expenses incurred but not
yet paid in cash or
recorded.
LO 4 Identify the major types of adjusting entries.
Adjusting Entries for Deferrals
Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
LO 5
Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.
BEFORE
Cash
Expense
Payment
Recorded
Prepayments often occur in
insurance
rent
supplies
maintenance on equipment
advertising
fixed assets (depreciation)
LO 5
Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Prepaid Expenses
Costs that expire either with the
passage of time or through use.
Adjusting entries (1) to record the
expenses that apply to the current
accounting period, and (2) to show the
unexpired costs in the asset accounts.
LO 5
Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Illustration 3-4
Adjusting entries for prepaid
expenses
Increases (debits) an expense account and
Decreases (credits) an asset account.
LO 5
Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Example (Insurance): On Jan. 1st, Phoenix
Consulting paid $12,000 for 12 months of insurance
coverage. Show the journal entry to record the payment on
Jan. 1st.
Prepaid Insurance
12,000
Jan. 1
Cash
Prepaid Insurance
Debit
12,000
Cash
Credit
Debit
12,000
Credit
12,000
LO 5
Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Example (Insurance): On Jan. 1st, Phoenix Consulting paid
$12,000 for 12 months of insurance coverage. Show the
adjusting journal entry required at Jan. 31st.
Jan. 31
Insurance Expense
1,000
Prepaid Insurance
1,000
Prepaid Insurance
Insurance Expense
Debit
Debit
12,000
Credit
1,000
Credit
1,000
11,000
LO 5
Prepare adjusting entries for deferrals.
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
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
Prepaid Insurance Example
 What was the determining factor in
matching this expense?
Time
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.
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.
Accrued Expenses Example
April
May
1 2 3
26 27
28 29 30
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
Accrued Salaries Expenses
To accrue salary expense
12,000
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.
Accrued Revenues Example
 What is the April 30 adjusting entry?
 April 30, 2005
Accrued service Receivable 15,000
Service Revenue
15,000
To accrue service revenue
Accrued Revenues Example
 What is the determining factor in
recognizing this service revenue?
Performance
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
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
Notice
 Adjusting entries always have...
– one income statement account and...
– one balance sheet account.
 Adjusting entries never involve cash.
Objective 4
Prepare an adjusted
trial balance.
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.
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.
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
Adjusting Entries for “Depreciation
”
Buildings, equipment, and vehicles
(long-lived assets) are recorded as
assets, rather than an expense, in
the year acquired.
Companies report a portion of the
cost of a long-lived asset as an
expense (depreciation) during each
period of the asset’s useful life
LO 5
Prepare adjusting entries for deferrals.
(Matching Principle).
Adjusting Entries for “Depreciation”
Example (Depreciation): On Jan. 1st, Phoenix Consulting paid
$24,000 for equipment that has an estimated useful life of 20
years. Show the journal entry to record the purchase of the
equipment on Jan. 1st.
24,000
Equipment
Cash
Jan. 1
Equipment
Debit
24,000
Cash
Credit
Debit
24,000
Credit
24,000
LO 5
Prepare adjusting entries for deferrals.
Adjusting Entries for “Depreciation”
Example (Depreciation):
On Jan. 1st, Phoenix Consulting
paid $24,000 for equipment that has an estimated useful life of
20 years. Show the adjusting journal entry required at Jan. 31st.
($24,000 / 20 yrs. / 12 months = $100)
Jan. 31
Depreciation Expense
Accumulated Depreciation
Depreciation Expense
Debit
100
100
Accumulated Depreciation
Credit
Debit
100
Credit
100
LO 5
Prepare adjusting entries for deferrals.
Adjusting Entries for “Depreciation”
Depreciation (Statement Presentation)
Accumulated Depreciation is a contra asset account.
Appears just after the account it offsets
(Equipment) on the balance sheet.
Balance Sheet
Jan. 31
Assets
Equipment
Accumulated Depreciation
Net Equipment
LO 5
24,000
(100)
23,900
Prepare adjusting entries for deferrals.
Depreciation Example
 On January 2, Wood Enterprise purchased
a truck for $30,000 cash.
 The truck is expected to last for 3 years.
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?
Depreciation Example
Dec. 31, 2005
Depreciation Expense
10,000
Accumulated Depreciation
10,000
To record depreciation on truck
Objective 5
Prepare the financial
statements from the
adjusted trial balance.
Financial Statements
 Financial statements have two parts:
1 The first part includes the following:
– name of the entity
– title of the statement
– date or period covered
2 The second part is the body of the
statement.
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
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
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
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
Trial Balance
Trial Balance – Each account is analyzed to determine
whether it is complete and up-to-date.
Phoenix Consulting - Jan. 31st (before adjusting entries)
Acct. No.
100
105
110
120
130
200
210
220
300
400
Account
Cash
Accounts receivable
Prepaid insurance
Equipment
Investments
Accounts payable
Unearned revenue
Note payable
Austin, capital
Sales
Debit
$
Credit
50,000
35,000
12,000
24,000
300,000
$
$ 421,000
20,000
24,000
200,000
40,000
137,000
$ 421,000
LO 4 Identify the major types of adjusting entries.
End