Chapter 3: The Matching
Concept and the Adjusting
Process
I. Matching Concept
• Reporting revenues and expenses
incurred to create the revenue are
reported in the same accounting period.
Question
• If rent for May is paid on June 1, in which
month will be reported as rent expense?
– May?
– June?
Answer:
• It depends on whether the business is run in a
“cash basis” or an “accrual basis”
– Accrual basis: May
– Cash basis: June
• Accrual basis: revenues reported as earned;
expenses reported when incurred, e.g.,
matching the expenses to the revenues
recorded.
• Cash basis: revenues reported when received;
expenses reported when paid.
Accrual Basis Business Applies for
Loan and Required to Provide List
of Monthly Expenses
•
•
•
•
•
•
•
Checkbook shows the following checks:
$375: rent
$110: utilities
$200: car payment
$480: ½ year of car insurance
$120: 1 year of life insurance
$20: paying for credit purchases last year
How to Report?
•
•
•
•
•
•
Rent: ?
Utilities: ?
Car Payment: ?
Car insurance: ?
Life insurance: ?
Credit Card: ?
Answer:
•
•
•
•
•
•
•
Rent: Same as check
Utilities: Same as check
Car Payment: Same as check
Car insurance: 480/6 months = $80/month
Life insurance: $120/12 = $10/month
Credit Card: Same as check
Note: If entire insurance payments are reported
as monthly expenses, monthly expenses will be
overstated.
– Illustration of the “matching” concept.
Similar problem:
• What if the business had received $10,000
loan, with principal and interest of 12% to
be paid 12 months after receipt of funds?
• Issue?
Issue:
• Not all business expenses for the month
are paid monthly.
• The business must consider all expenses
incurred for the month:
– $10000(.12)= $1200/year = $120/month
Similar problem:
• What if the business made $100 in sales to
customers but payment not received until 2
months later?
• Must show $200 revenue earned for the period
even though unpaid.
• GAAP: Net Income: Revenues earned from sale
of services during the period – expenses
incurred in providing those services.
– Match expenses against revenues they generate
Accrual basis accounting requires
adjusting entries
• How much of the Accounts Receivables
earned during the month?
• How much of the Supplies were used
during the month?
Exercise: Net Income for Brick
Layers Inc. for the month of June
• $1200: Fees earned for a brick patio.
• $400: Bricks purchased on account to be
paid in July.
• $20: 2 cement bags purchased and paid in
June
• $200: laborers’ pay at the end of the work.
• $600/moth: Other monthly expenses paid
for rent, utilities, insurance, etc.
NET INCOME
• Revenues: ?
• Expenses:
– Bricks:?
– Cement: ?
– Wages: ?
– Other expenses: ?
• Net Profit: ?
NET INCOME
• Revenues: ?
• Expenses:
– Bricks:?
– Cement: ?
– Wages: ?
– Other expenses: ?
• Net Profit: ?
Net Income
• Revenues:
• Expenses:
1200
– Bricks: 400
– Cement: 20
– Wages: 200
– Other expenses: ¼ of $600: $150
– Total Expenses
770
• Net Profit:
430
II. Adjusting Entries
• Why?
– Accrual basis requires that we update
accounting records so that all revenues
earned and all expenses incurred are properly
recorded.
Types of adjusting entries:
• Deferral = cash transfers hands in current
period in payment for performance in
future periods.
– Deferred cash today for future performance
• Accruals = Performance in current period
and cash transfers hands in future periods.
– Accrue performance today for future cash
Deferrals:
• Deferred Expense:
– When you pay for an item in advance (before
it is actually used), e.g., a prepaid expense.
– 1st recorded as an asset.
– As the asset is used, adjusting entries reflect
a transfer from the asset to an expense:
• Supplies
• Prepaid insurance
Supplies: Recorded as an asset when
purchased.
• As supplies are used each month, an
adjusting entry is required to transfer the
cost of supplies from an asset account to
an expense account.
Example
• On December 5, the business purchased
$250 in supplies. On 12/31 the ending
inventory in supplies was $50.
• Original entry
– Supplies…………………………250
–
Cash…………………………..250
• Adjusting entry
– Supplies expense…………….. 200
–
Supplies…………………...….200
Prepaid insurance: Recorded as an
asset when purchased.
• As the policy expires, each month the
asset is being used up.
• So an adjusting entry is required to
transfer the cost of insurance from an
asset account to an expense account
Example
• On December 1, the business purchased
a 6-month insurance policy. On December
31, how do you record insurance?
• Original entry
– Prepaid insurance………. 600
–
Cash…………………….. 600
• Adjusting entry
– Insurance Expense……….. 100
–
Prepaid Insurance………100
Deferred revenue:
• Occurs when you get paid before you earn it,
e.g., unearned revenues.
– Cash has been received for goods but as goods have
not been delivered, the cash has not being earned.
• Records receipt of cash against a liability that
reflects unearned revenues, e.g., a promise to
deliver goods or services in the future.
• After delivery, revenues are earned, so a
corresponding portion of the liability is
transferred to revenue, e.g., revenue is
recognized.
Example
• On 11/2 the business received 3 months rent in
advance or $2400. What is the entry at EOY?
• Original entry
– Cash …………………... 2400
–
Unearned rent ……………..2400
• Adjusting entry
• Unearned rent……………1600
•
Rent income
1600
• Note: “unearned” = liability in Balance Sheet;
“earned” = revenue in Income Statement
Accruals
• Accrued expense: expenses incurred
before payment.
– Assume electricity is paid on the 15th of the
following month: A daily utility expense is
incurred but not paid. Others: Accrued wages,
accrued interest.
• Accrued revenues: revenues are earned
but not recorded. A business is not paid for
services rendered during the month until
the 10th of the following month. Other:
accrued interest on notes receivable.
Example
• On Wednesday 12/31, the business owes
$500 in wages. Payroll is Friday.
• Original entry: None
• Adjusting entry:
• Wages Expense….............…500
•
Wages Payable……………….500
Example
• At EOY the business is owed $80 in
interest.
• Original entry: None
• Adjusting entry:
– Interest receivable ……………80
–
Interest Income…………………..80
Depreciation
• Applicable only to assets with a long life, e.g., fixed
assets
• While use of supplies is reflected by the quantity used,
e.g., total supplies decreases as used, one building
continues to be one building. However, as the equipment
gets older, performance decreases.
• The decrease in performance or usefulness is known as
“depreciation”.
• Decrease for the period is a function of “useful life”.
– Useful life is an artificially created # of years the asset is
expected to be useful.
Recording Depreciation
• Depreciation expense reflects the periodic
decrease in the building usefulness for
the period being reported.
– Debit Depreciation Expense
– Credit Accumulated Depreciation
• Contra asset account
– Asset increases are denoted with debits
– Contra asset increases are denoted with credits
– Do not credit the original asset. Prices are
reflected at their original cost.
An analogy
• You need 4 tires. One set costs $200 with
a life estimate of 20,000 miles. The other
set costs $300 with a life estimate of
40,000 miles. If you drive 10,000
miles/year and are keeping the car for at
least 4 years, which is the best buy?
Estimating Cost
• $200 set is estimated to last 20,000 miles or 2 years.
Thus, cost = $100/year
• $300 set is estimated to last 40,000 miles or 4 years.
Thus cost = $75/year.
• Upon purchase of $300 set, it is recorded as an asset.
Every year, $75 is transferred to an expense account.
• Original entry
– Tires……………………………….300
–
Cash………………………………..……300
• Adjusting entry at EOY:
– Depreciation expense…………..…75
–
Accumulated Depreciation…………….75
Exercise:
• An accrual business buys a building in an
area where real estate is increasing at
6%/year. You record depreciation.
• Why record depreciation when values are
going up?
Answer
• Depreciation is not related to the value of
the asset.
• Depreciation is an estimate of the asset’s
usefulness that has expired during the
period.
• The original cost and the accumulated
depreciation are reported in the Balance
Sheet. Two separate accounts.
Exercise: Prepare journal entries
from trial balances
• Unadjusted/Adjusted:
– Supplies 200/140
– Prepaid insurance 400/210
– Wages Payable 0/130
– Unearned revenue 100/30
– Fees earned: 7200/7330
– Supplies expense 0/60
– Insurance expense 0/190
Answer
• Supplies expense…………60
•
Supplies………………………60
– Expl: Supplies at BOY=200; EOY=140
• Insurance expense……….190
•
Prepaid insurance…………….190
– Expl: Prepaid insurance BOY:400; EOY 210
• Wages Expense……………….130
•
Wages Payable………………130
– Expl: $130 wages accrued but not paid at EOY
• Unearned Revenue……………70
•
Fees earned ……………………..70
– Expln: Unearned fees at EOY