measuring business profit: the adjusting process chapter 3 horngren ♦ harrison ♦ bamber ♦ best...

Measuring Business Profit:

The Adjusting ProcessChapter

3

HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

3 - 2Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia

Objectives

1. Distinguish accrual-basis accounting from cash-basis accounting.

2. Make adjusting entries at the end of the accounting period.

3. Prepare an adjusted trial balance.

4. Prepare the financial statements from the adjusted trial balance.


Distinguish accrual-basis

accounting fromcash-basis accounting.

Objective 1


Accrual-basis:Transactions are recorded

when revenues areearned or expenses

are incurred.

Accrual-basis:Transactions are recorded

when revenues areearned or expenses

are incurred.

Cash-basis:Transactions arerecorded whencash is paid or

cash is received.

Cash-basis:Transactions arerecorded whencash is paid or

cash is received.

The Two Bases of Accounting:


Accrual Versus Cash Example

In January 2004, 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 profit or loss?



Accrual-Basis Accounting2004 2005 20062004 2005 2006(000 omitted)

Revenues $50 $50 $50Expenses 20 20 20Net profit (loss) $30 $30 $30



Cash-Basis Accounting2004 2005 20062004 2005 2006(000 omitted)

Cash inflows $150 $ 0 $ 0Cash outflows 20 20 20Net profit (loss) $130 ($20) ($20)


Managers adopt anartificial period of time

to evaluate performance.

Managers adopt anartificial period of time

to evaluate performance.

Accounting Period


MonthlyMonthly

QuarterlyQuarterly

Half-yearlyHalf-yearly

Interim Period Statements


Revenue Principle

When is revenue recognised? 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 recognised 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 profit recognised?


Revenues $15,000Cost of goods sold 8,000Net profit $ 7,000

May

Matching Expenses with Revenues Example


Interacts with the revenue principle and the matching principle

Interacts with the revenue principle and the matching principle

Requires that profit be measured

accurately each period

Requires that profit be measured

accurately each period

The Time Period Concept

It requires that accounting information be reported at regular intervals.


Make adjusting entries at the

end of the accounting period.

Objective 2


Adjusting Entries

Assign revenue to the period earned. Assign expenses to the period incurred. Bring related asset and liability accounts

into correct balance.


Prepaids or DeferralsPrepaids or Deferrals

AccrualsAccruals

Two Types OfAdjusting Entries


Prepaid expensesPrepaid expenses

DepreciationDepreciation

Accrued expensesAccrued expenses

Accrued revenuesAccrued revenues

Unearned revenuesUnearned revenues

Five Categories OfAdjusting Entries


36,000

CashPrepaid Insurance

36,000

Prepaid Insurance Example

On July 2, 2004, Tsai Tools paid $36,000

for a three-year health insurance policy.



What is the journal entry on June 30, 2005?

Insurance Expense 12,000 Prepaid Insurance

12,000

To record insurance expense


TimeTime


What was the determining factor in matching this expense?


Supplies Example

Elderly Enterprise started business at the beginning of the month.

$800 worth of office supplies were purchased on November 15, 2004, for cash.


Office Supplies Cash

800 800

An inventory at month end indicatedthat $200 in office supplies remained.

What is the supplies expense?

Supplies Example


UsageUsage

Supplies Expense600

Supplies 800 600

Bal. 200

Supplies Example

What was the determining factor in matching this

expense?


Depreciation Example

On July 1, 2003 Ahmed Arbourists 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 revenue.

What is the journal entry for the year ended June 30, 2004?

Depreciation Expense 10,000

Accumulated Depreciation 10,000To record depreciation on truck


A contra account has a companion

account.

A contra account has a companion

account.A contra account’s normal balance is opposite that of the companion

account.

A contra account’s normal balance is opposite that of the companion

account.Accumulated

depreciation is a contra account to

truck assets.

Accumulateddepreciation is a contra account to

truck assets.

Contra Accounts


Ahmed Arbourists Example

Partial Balance SheetJune 30, 2004

Plant assets:Machinery $30,000Less: Accumulated depreciation 10,000

Total $20,000

Contra accountContra accountBook 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 again on May 3.


April May

2626 27

28 29 30

1 2 33




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, 2004

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.



What is the April 30 adjusting entry? April 30, 2004

Accounts Receivable 15,000 Service Revenue

15,000 To accrue service revenue


PerformancePerformance


What is the determining factor in recognising this service revenue?


Unearned or Deferred Revenue Example

In January 2004, Prensa Insurance received $150,000 from a business client to provide health insurance coverage for three years.

January 2, 2004 Cash 150,000 Unearned Revenue 150,000

Received revenue in advance


Correctliability

$100,000

Correctliability

$100,000

Totalaccounted for

$150,000

Totalaccounted for

$150,000

Correctrevenue$50,000

Correctrevenue$50,000

Unearned or Deferred Revenue Example

What is the journal entry on December 31, 2004?

Unearned revenue 50,000 Revenue 50,000

To record revenue collected in advance


Notice

Adjusting entries always have...– one statement of financial performance

account and...– one statement of financial position

account. Adjusting entries nevernever involve cash.


Prepare an adjusted

trial balance.

Objective 4


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.

See exhibit 3.8 page 106 of your textbook


Prepare the financial

statements from the

adjusted trial balance.

Objective 5


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.


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 profit $30,000

Prensa InsuranceStatement of financial

performanceYear Ended December 31, 2004


Prensa Insurance Equity, January 1, 2004 $100,000Add: Net profit 30,000Prensa Insurance Equity, December 31, 2004 $130,000


Prensa InsuranceStatement of Owner’s Equity

Year Ended December 31, 2004


Assets: Cash $189,150 Accounts receivable 5,000 Supplies 100 Prepaid rent 1,000 Office equipment 5,000 Less: Accumulated depreciation 250 4,750Total assets $200,000


Prensa InsuranceStatement of Financial Position

As At December 31, 2004


Liabilities: Electricity payable $ 150 Interest payable 600 Accounts payable (supplies) 250 Salaries payable 4,100 Bank loan 64,900Total liabilities $ 70,000

Total Owner’s equity 130,000

Total liabilities and owner’s equity $200,000



End of Chapter 3

measuring business profit: the adjusting process chapter 3 horngren ♦ harrison ♦ bamber ♦ best...

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