CHAPTER 3 … Measuring Business Income: Adjusting Process
Objective 1: Distinguish accrual accounting from cash-basis accounting
A.
To measure income, businesses must apply accounting principles and concepts, such as
accrual accounting, the accounting period, the revenue principle, and the matching
principle.
1.
2.
B.
In accrual accounting, the accountant enters the transactions when the business
performs a service or incurs an expense.
a.
The effect of every transaction is recorded when the transaction occurs,
not just when cash is received or paid. (Exhibit 3-1 compares the accrualbasis and cash-basis of accounting.)
b.
Accrual accounting is the more correct and common method used.
In some cases, accountants use cash-basis accounting. In cash-basis accounting,
cash receipts are treated as revenues, and cash payments are treated as expenses.
The accounting period for most businesses is one year. At this time, a business
measures its income.
1.
The only way to know for certain how successfully a business has operated is to
liquidate, which means to go out of business. However, a business needs to have
information on a regular basis. Most businesses divide their life into smaller
segments, usually a year.
2.
Some businesses use the calendar year—January 1- December 31.
3.
Other businesses use a fiscal year usually corresponding with a low point in
business activity.
4.
Companies also prepare interim financial statements covering months or quarters.
Objective 2: Apply the revenue and matching principles
A.
Three accounting principles and concepts underlie the use of accrual accounting.
1.
The revenue principle states that revenues are recorded when earned, and the
amount of revenue recorded equals the cash value of the goods or services
transferred to the customer. (Exhibit 3-2 illustrates the revenue principle.)
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B.
2.
The matching principle states that expenses should be deducted from (matched
against) the revenues earned in the same period. (Exhibit 3-3 illustrates the
matching principle.)
3.
The time-period concept requires that accounting information be reported at
regular intervals and that income be measured accurately each period. To
measure income accurately, companies update their accounts at the end of each
period. This process also helps to properly match revenues and expenses.
In order to completely measure income, journal entries called adjusting entries must be
prepared at period end to ensure that all revenues and expenses have been recorded
properly.
Objective 3: Make adjusting entries
A.
B.
Adjusting entries assign revenues and expenses not previously recorded to the proper
accounting period as well as bringing related asset and liability accounts to correct
balances for the balance sheet.
1.
The trial balance or the unadjusted trial balance lists the accounts and their
balances after the period’s transactions have been recorded. These trial balance
amounts are incomplete because they do not reflect certain revenue and expense
transactions that affect more than one accounting period. (The information
provided in the unadjusted trial balance in Exhibit 3-4 is used to illustrate the
adjusting entries.)
2.
Adjusting entries assign revenues to the period when they are earned and
expenses to the period when they are incurred.
3.
Adjusting entries also bring related asset and liability accounts to correct balances
for the balance sheet.
4.
Adjusting entries are always required when using accrual accounting but never
required when using the cash-basis.
Adjusting entries can be divided into prepaids and accruals. Exhibit 3-7 illustrates the
prepaid and accrual adjustments.
1.
Prepaid adjustments are needed when the cash transaction occurs before the
related expense or revenue is recorded. Prepaid expenses, depreciation, and
unearned revenue are prepaid-type adjustments.
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2.
C.
Accrual adjustments are needed when the cash transaction occurs after the
related expense or revenue is recorded. Accrued revenue and accrued expenses
require accrual-type adjustments.
Adjusting entries can be further divided into five categories: prepaid expenses,
depreciation, accrued expenses, accrued revenues, and unearned revenues.
1.
Prepaid expenses require adjustment because the cash is paid in one period, but
the resource is not completely used until a later period.
a.
The entry to record the payment for the prepaid expense increases the
asset and decreases cash.
Prepaid Insurance (or Supplies)
Cash
b.
XX
XX
The adjusting entry records an expense and a decrease in the asset; the
entry reflects the amount expired or used up.
Insurance (Supplies) Expense
XX
Prepaid Insurance (Supplies) XX
2.
(↑ asset; debit)
(↓ asset; credit)
(↑ expense; debit)
(↓ asset; credit)
Long-lived assets, such as buildings and equipment, are used up over several
years. Depreciation is the allocation of the cost of a plant asset to expense over
its useful life. (Exhibits 3-5 and 3-6 show two different financial statement
presentations of plant assets.)
a.
Depreciation is similar to prepaid expenses in that an asset is recorded
when the plant asset is acquired. The asset is expensed as it is used.
Depreciation Expense
XX
Accumulated Depreciation
b.
XX
(↑ expense; debit)
(↓ asset; credit)
As the asset depreciates, the asset value declines. Instead of reducing the
asset account, another account, Accumulated Depreciation, is used.
1)
Accumulated depreciation is a contra asset account; that is, an
asset account with a credit balance. A contra account always
appears following its companion account on the financial
statements.
2)
The balance of the Accumulated Depreciation account is the sum
of all depreciation recorded to date for the asset.
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2)
The book value of the asset is determined by the following
formula:
Book value = Cost of asset – Accumulated depreciation
3.
Accrued expenses are expenses that are incurred (because a good or service has
been used) by the end of the period but will not be paid until a later period. The
adjusting entry records an expense for the amount used and a liability for the
amount not yet paid. Salaries, interest, and taxes are examples of accrued
expenses.
Salary Expense
Salary Payable
4.
Accrued revenues are revenues that have been earned (because the good or
service has been delivered) but not yet received. The adjusting entry records
revenue (because the revenue has been earned) and a receivable (because the cash
is not yet collected). Interest and service revenue are examples of accrued
revenues.
Interest Receivable
Interest Revenue
5.
(↑ asset; debit)
(↑ revenue; credit)
XX
XX
Unearned revenues arise when a business receives cash in one period but does
not earn all of it until a later period.
a.
An unearned revenue is a liability because the business owes the customer
a good or service. The receipt of the cash increased cash and increased a
liability.
Cash
XX
Unearned Revenue
b.
XX
(↑ asset; debit)
(↑ liability; credit)
The adjusting entry records the part of the unearned revenue that has been
earned.
Unearned Revenue
Service Revenue
D.
(↑ expense; debit)
(↑ liability; credit)
XX
XX
XX
XX
(↓ liability; debit)
(↑ revenue; credit)
In summary, each adjusting entry adjusts an income statement account—either a revenue
or an expense. Each adjusting entry also adjusts a balance sheet account—either an asset
or a liability. No adjusting entry ever adjusts the balance of Cash. (Exhibit 3-8
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summarizes the adjusting entries and Exhibit 3-9 illustrates all of the adjusting entries
and T-accounts for Cookie Lapp Travel Design)
Objective 4: Prepare an adjusted trial balance
A.
The adjusted trial balance is prepared after the adjusting entries. (Exhibit 3-10 shows
the trial balance, adjustments, and the adjusted trial balance in work sheet form for.
Cookie Lapp Travel Design)
B.
The adjusted trial balance serves as the basis for the preparation of the financial
statements.
Objective 5: Prepare the financial statements from the adjusted trial balance
A.
The financial statements are prepared using the account balances found on the adjusted
trial balance. (Exhibits 3-11, 3-12, and 3-13 are the income statement, statement of
owner’s equity, and the balance sheet, respectively, of Gay Gillen eTravel.)
B.
The income statement is prepared first, followed by the statement of owner’s equity, and
then the balance sheet.
C.
The following information should be considered in the preparation of the financial
statements:
1.
2.
The heading of the statement should include:
a.
the name of the entity,
b.
the title of the statement, and
c.
the date or period covered by the statement.
On the income statement, expenses are listed in descending order by amount,
except for Miscellaneous Expense, which is usually listed last.
D.
Exhibits 3-11, 3-12, and 3-13 also show the relationships among the three financial
statements.
E.
Accrual accounting provides some ethical challenges that cash accounting avoids.
1.
Since expenses are not necessarily expensed when paid in accrual accounting,
management can exercise some discretion when recording expenses.
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F.
2.
Accrual accounting provides opportunities for unethical accounting. Failure to
prepare adjusting entries can cause an error in net income.
3.
It is important for accountants to prepare accurate and complete financial
statements because people rely on the data for their decisions.
Decision Guidelines ask important questions about accrual accounting, the adjusting
process, and the adjusted trial balance.
Appendix
A.
Prepaid expenses are advance payments of expenses.
B.
Prepaid expenses require adjustment because the cash is paid in one period, but the
resource is not completely used until a later period.
1.
The entry to record the payment for the prepaid expense can increase the asset and
decrease cash, or, alternatively, increase an expense and decrease cash.
Record as Asset
Prepaid Rent
expense)
Cash
(↓ asset)
2.
Record as Expense
(↑ asset)
Rent Expense
XX
(↓ asset)
Cash
XX
The adjusting entry for each method is:
Record as Asset
Rent Expense
XX
asset)
Prepaid Rent
expense)
Record supplies used.
C.
(↑
XX
XX
Record as Expense
(↑ expense)
XX
(↓ asset)
Prepaid Rent
(↑
XX
Rent Expense
XX
(↓
Record supplies not used.
The balance sheet and income statement will report the same amounts regardless of the
method used to originally record the payment.
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D.
Unearned (deferred) revenues arise when a business receives cash in one period but
does not earn all of it until the next period.
1.
The entry to record the receipt of the unearned revenue can increase the liability
and increase cash, or, alternatively, can increase revenue and increase cash.
Record as Liability
2.
Record as Revenue
Cash
XX
(↑ asset)
Unearned Revenue
revenue)
XX
(↑ asset)
(↑ liability)
Cash
Service Revenue
XX
XX
(↑
The adjusting entry for each method is:
Record as Liability
Unearned Revenue XX
Service Revenue
liability)
Record revenue earned.
Record as Revenue
(↓ liability) Service Revenue
XX
XX
(↑ revenue)
Unearned Revenue
(↓ revenue)
XX
(↑
Record revenue not earned.
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