Measuring Business Income:
The Adjusting Process
ACCT 201
LECTURE 5
Chapter 3
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
2003
2004
Revenues
$50
Expenses
20
Net income (loss) $30
$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
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
Supplies Example
Wood Enterprise started business the
beginning of the month.
 $800 worth of office supplies were
purchased on November 15, 2004, for
cash.

Supplies Example
Office Supplies
800
Cash
800
An inventory at month end indicated
that $200 in office supplies remained.
What is the supplies expense?
Supplies Example
Supplies Expense
600
Supplies
800 600
Bal. 200
What was the determining
factor in matching this
expense?
Usage
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
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
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
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
Salaries Payable
12,000
To accrue salary expense

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
Accounts 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.

Objective 5
Prepare the financial
statements from the
adjusted trial balance
Financial Statements

1
–
–
–
2
Financial statements have 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.
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
REVISION QUESTIONS
1)Tom owns a tree trimming service.
During October, he did $700 worth of
work. Of that amount, customers paid
$400 in cash when the work was done.
Tom billed the rest of the customers.
How much revenue would Tom
recognize in October using the cash
basis of accounting?
2) Tom owns a tree trimming service.
During October, he did $700 worth of
work. Of that amount, customers paid
$400 in cash when the work was done.
Tom billed the rest of the customers for
the rest. How much revenue would
Tom recognize in October using the
accrual basis of accounting?
3) An interim accounting period can
be all of the following except:
1.
2.
3.
4.
Monthly
Quarterly
Semiannually
Annually
4) Which accounting principle tells
accountants when to record revenues?
1.
2.
3.
4.
Matching
Revenue
Cost
Entity
5) Which accounting principle tells
accountants when to record expenses?
1.
2.
3.
4.
Matching
Revenue
Cost
Entity
6) Which of the following is not a
purpose of adjusting entries?
1.
2.
3.
4.
Assign revenues to the period when they
are earned
Properly determine net income on the
income statement
Update the asset accounts
Update the capital account
7) What type of account is prepaid
insurance?
1. Asset
2. Liability
3. Revenue
4. Expense
8) On December 1, Elba Company paid $600 for
three month’s rent in advance. What adjusting
entry would be prepared on December 31?
1.
2.
3.
4.
Debit prepaid rent and credit cash, $600
Debit rent expense and credit prepaid rent, $600
Debit rent expense and credit prepaid rent, $200
Debit prepaid rent and credit rent expense, $200
9) The December 31 unadjusted trial balance
lists Supplies with a $200 debit balance. On
December 31, a physical count of supplies
show that $50 of supplies are still on hand.
What adjusting entry should be prepared on
December 31?
1.
2.
3.
4.
Debit Supplies Expense; credit Supplies for
$150
Debit Supplies Expense; credit Cash for $50
Debit Supplies Expense; credit Supplies for $50
Debit Supplies Expense; credit Cash for $150
10) What type of account is unearned
revenue?
1.
2.
3.
4.
Asset
Liability
Revenue
Expense
11) Oak Company rents part of its office
building for $200 a month. On May 1, Oak
Company received four month’s rent in
advance, which was credited to Unearned Rent
Revenue. What entry should be prepared on
May 31?
1.
2.
3.
4.
Debit unearned rent revenue; credit rent revenue,
$200
Debit unearned revenue; credit rent revenue,
$800
Debit cash; credit rent revenue, $800
Debit cash; credit rent revenue, $200
12) An expense that is expensed first
and paid later is called
1.
2.
3.
4.
An unearned revenue
Depreciation expense
An accrued expense
A prepaid expense
13) Elm Company has a five-day work week
that ends on Friday. It’s total payroll for the
week is $500. If the end of the accounting
period falls on a Wednesday, what adjusting
entry should be prepared?
Debit salary expense; credit cash, $300
 Debit salary expense; credit cash, $500
 Debit salary expense; credit salary payable,
$300
 Debit salary expense; credit salary payable,
$500

14) Maple Company holds a note receivable
of $5,000. The note is due to be paid in
January. As of the end of the accounting
period, Maple has earned $200 interest.
What adjusting entry should be prepared?
1.
2.
3.
4.
Debit interest expense; credit interest revenue,
$200
Debit interest expense; credit interest payable,
$200
Debit interest receivable; credit interest payable,
$200
Debit interest receivable; credit interest revenue,
$200
15) On January 1, 2005, Ash Company
purchased a truck that cost $30,000. The
company depreciates the asset $3,000 per
year. What is the truck’s book value at
December 31, 2006?
1.
2.
3.
4.
$24,000
$21,000
$30,000
$27,000
16) Which of the following is most helpful
in preparing the financial statements?
1.
2.
3.
4.
Trial balance
Adjusted trial balance
Journal
Chart of accounts