ch03
TRANSCRIPT
3 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Business Income:
The Adjusting ProcessChapter
3
3 - 2©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Distinguish accrual-basisaccounting from
cash-basis accounting.
Objective 1
3 - 3©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Accrual-basis:Transactions are recorded
when revenues areearned or expenses
are incurred.
Cash-basis:Transactions arerecorded whencash is paid or
cash is received.
The Two Bases of Accounting:
3 - 4©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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?
3 - 5©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Accrual Versus Cash Example
Accrual-Basis Accounting2002 2003 2004(000 omitted)
Revenues $50 $50 $50Expenses 20 20 20Net income (loss) $30 $30 $30
3 - 6©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Accrual Versus Cash Example
Cash-Basis Accounting2002 2003 2004(000 omitted)
Cash inflows $150 $ 0 $ 0Cash outflows 20 20 20Net income (loss) $130 ($20) ($20)
3 - 7©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Managers adopt anartificial period of time
to evaluate performance.
Accounting Period
3 - 8©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Monthly
Quarterly
Semi-annually
Interim Period Statements
3 - 9©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Apply the revenue andmatching principles.
Objective 2
3 - 10©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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.
3 - 11©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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.
3 - 12©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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?
3 - 13©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Revenues $15,000Cost of goods sold 8,000Net income $ 7,000
May
Matching Expenses with Revenues Example
3 - 14©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Interacts with the revenue principle and the matching principle
Requires that income be measured
accurately each period
The Time Period Concept
It requires that accounting information be reported at regular intervals.
3 - 15©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Make adjusting entries at theend of the accounting period.
Objective 3
3 - 16©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Adjusting Entries
Assign revenue to the period earned. Assign expenses to the period incurred. Bring related asset and liability accounts
into correct balance.
3 - 17©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Prepaids or Deferrals
Accruals
Two Types OfAdjusting Entries
3 - 18©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Prepaid expenses
Depreciation
Accrued expenses
Accrued revenues
Unearned revenues
Five Categories OfAdjusting Entries
3 - 19©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
24,000CashPrepaid Insurance
24,000
Prepaid Insurance Example
On January 2, 2002, Parker Floor paid $24,000for a two-year health insurance policy.
3 - 20©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Prepaid Insurance Example
What is the journal entry on December 31, 2002?
Dec. 31, 2002 Insurance Expense 12,000
Prepaid Insurance 12,000 To record insurance expense
3 - 21©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Time
Prepaid Insurance Example
What was the determining factor in matching this expense?
3 - 22©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Supplies Example
Wood Enterprise started business the beginning of the month.
$800 worth of office supplies were purchased on November 15, 2001, for cash.
3 - 23©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Office Supplies Cash800 800
An inventory at month end indicatedthat $200 in office supplies remained.
What is the supplies expense?
Supplies Example
3 - 24©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Usage
Supplies Expense600
Supplies 800 600
Bal. 200
Supplies Example
What was the determining factor in matching this expense?
3 - 25©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Depreciation Example
On January 2, Wood Enterprise purchased a truck for $30,000 cash.
The truck is expected to last for 3 years.
3 - 26©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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, 2002?
3 - 27©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Dec. 31, 2002Depreciation Expense 10,000
Accumulated Depreciation 10,000To record depreciation on machinery
Depreciation Example
3 - 28©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
A contra account has a companion
account.A contra account’s normal balance is opposite that of the companion
account.Accumulateddepreciation is a contra account to
plant assets.
Contra Accounts
3 - 29©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Wood Enterprise Example
Partial Balance SheetDecember 31, 2002
Plant assets:Machinery $30,000Less: Accumulated depreciation 10,000
Total $20,000
Contra accountBook value
3 - 30©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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.
3 - 31©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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.
3 - 32©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
April May
26 27
28 29 30
1 2 3
Accrued Expenses Example
3 - 33©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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
3 - 34©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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.
3 - 35©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Accrued Revenues Example
What is the April 30 adjusting entry? April 30, 2002
Accounts Receivable 15,000 Service Revenue
15,000 To accrue service revenue
3 - 36©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Performance
Accrued Revenues Example
What is the determining factor in recognizing this service revenue?
3 - 37©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Unearned or Deferred Revenue Example
In January 2002, Prensa Insurance received $150,000 from a business client to provide health insurance coverage for three years.
January 2, 2002 Cash 150,000
Unearned Revenue 150,000 Received revenue in advance
3 - 38©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Correctliability
$100,000
Totalaccounted for
$150,000
Correctrevenue$50,000
Unearned or Deferred Revenue Example
What is the journal entry on December 31, 2002?
Unearned revenue 50,000 Revenue 50,000
To record revenue collected in advance
3 - 39©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Notice
Adjusting entries always have...– one income statement account and...– one balance sheet account. Adjusting entries never involve cash.
3 - 40©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Prepare an adjustedtrial balance.
Objective 4
3 - 41©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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.
3 - 42©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Prepare the financialstatements from the
adjusted trial balance.
Objective 5
3 - 43©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
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 covered2 The second part is the body of the
statement.
3 - 44©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Financial Statements Example
Revenue from insurance services $50,000Less: Salaries expense 14,275
Supplies expense 250Rent expense 3,600Utilities expense 625Interest expense 600Depreciation 650
Net income $30,000
Prensa InsuranceIncome Statement
Year Ended December 31, 2002
3 - 45©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Prensa Insurance Equity, January 1, 2002 $100,000Add: Net income 30,000Prensa Insurance Equity, December 31, 2002 $130,000
Financial Statements Example
Prensa InsuranceStatement of Owner’s Equity
Year Ended December 31, 2002
3 - 46©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Assets: Cash $189,150 Accounts receivable 5,000 Supplies inventory 100 Prepaid rent 1,000 Office equipment 5,000 Less: Accumulated depreciation 250
Total assets $200,000
Financial Statements Example
Prensa InsuranceBalance Sheet
Year Ended December 31, 2002
3 - 47©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Liabilities and Equities: Utilities payable $ 150 Interest payable 600 Accounts payable (supplies) 250 Salaries payable 4,100 Bank loan 64,900Total liabilities $ 70,000
Owner’s equity 130,000Total liabilities and owner’s equity $200,000
Financial Statements Example
3 - 48©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
End of Chapter 3