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Measuring Business Profit: The Adjusting Process

Measuring Business Profit: The Adjusting Process. Chapter 3. HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT. Objectives. Distinguish accrual-basis accounting from cash-basis accounting. Make adjusting entries at the end of the accounting period.

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Measuring Business Profit: The Adjusting Process

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  1. Measuring Business Profit:The Adjusting Process Chapter 3 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

  2. Objectives • Distinguish accrual-basis accounting from cash-basis accounting. • Make adjusting entries at the end of the accounting period. • Prepare an adjusted trial balance. • Prepare the financial statements from the adjusted trial balance.

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

  4. 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.

  5. 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?

  6. Accrual Versus Cash Example Accrual-Basis Accounting (000 omitted) 2004 2005 2006 Revenues $50 $50 $50 Expenses 20 20 20 Net profit (loss)$30 $30 $30

  7. Accrual Versus Cash Example Cash-Basis Accounting (000 omitted) 2004 2005 2006 Cash inflows $150 $ 0 $ 0 Cash outflows 20 20 20 Net profit (loss) $130 ($20) ($20)

  8. Accounting Period Managers adopt an artificial period of time to evaluate performance.

  9. Interim Period Statements Monthly Quarterly Half-yearly

  10. 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.

  11. 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.

  12. 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?

  13. Matching Expenses with Revenues Example May Revenues $15,000 Cost of goods sold 8,000 Net profit $ 7,000

  14. 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 profit be measured accurately each period

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

  16. Adjusting Entries • Assign revenue to the period earned. • Assign expenses to the period incurred. • Bring related asset and liability accounts into correct balance.

  17. Two Types OfAdjusting Entries Prepaids or Deferrals Accruals

  18. Five Categories OfAdjusting Entries Prepaid expenses Accrued revenues Depreciation Unearned revenues Accrued expenses

  19. Prepaid Insurance Example On July 2, 2004, Tsai Tools paid $36,000 for a three-year health insurance policy. Prepaid Insurance Cash 36,000 36,000

  20. Prepaid Insurance Example • What is the journal entry on June 30, 2005? • Insurance Expense 12,000 Prepaid Insurance 12,000 To record insurance expense

  21. Prepaid Insurance Example • What was the determining factor in matching this expense? Time

  22. 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.

  23. Supplies Example Office Supplies Cash 800 800 An inventory at month end indicated that $200 in office supplies remained. What is the supplies expense?

  24. Supplies Example What was the determining factor in matching this expense? Supplies Expense Supplies 800 600 Bal. 200 600 Usage

  25. Depreciation Example • On July 1, 2003 Ahmed Arbourists purchased a truck for $30,000 cash. • The truck is expected to last for 3 years.

  26. 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 10,000 To record depreciation on truck

  27. Contra Accounts A contra account has a companion account. A contra account’s normal balance is opposite that of the companion account. Accumulated depreciation is a contra account to truck assets.

  28. Ahmed Arbourists Example Partial Balance Sheet June 30, 2004 Plant assets: Machinery $30,000 Less: Accumulated depreciation 10,000 Total $20,000 Contra account Book value

  29. 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.

  30. 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.

  31. Accrued Expenses Example April May 1 23 2627 28 29 30

  32. 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, 2004 Salaries Expense 12,000 Salaries Payable 12,000 To accrue salary expense

  33. 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.

  34. Accrued Revenues Example • What is the April 30 adjusting entry? • April 30, 2004 Accounts Receivable 15,000 Service Revenue 15,000 To accrue service revenue

  35. Accrued Revenues Example • What is the determining factor in recognising this service revenue? Performance

  36. 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

  37. 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 Correct liability $100,000 Total accounted for $150,000 Correct revenue $50,000

  38. Notice • Adjusting entries always have... • one statement of financial performance account and... • one statement of financial position account. • Adjusting entries neverinvolve cash.

  39. Prepare an adjusted trial balance. Objective 4

  40. 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

  41. Prepare the financial statements from the adjusted trial balance. Objective 5

  42. Financial Statements • 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.

  43. Financial Statements Example Prensa Insurance Statement of financial performance Year Ended December 31, 2004 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 profit $30,000

  44. Financial Statements Example Prensa Insurance Statement of Owner’s Equity Year Ended December 31, 2004 Prensa Insurance Equity,January 1, 2004 $100,000 Add: Net profit 30,000 Prensa Insurance Equity,December 31, 2004 $130,000

  45. Financial Statements Example Prensa Insurance Statement of Financial Position As At December 31, 2004 Assets: Cash $189,150 Accounts receivable 5,000 Supplies 100 Prepaid rent 1,000 Office equipment 5,000 Less: Accumulated depreciation 2504,750 Total assets $200,000

  46. Financial Statements Example Liabilities: Electricity payable $ 150 Interest payable 600 Accounts payable (supplies) 250 Salaries payable 4,100 Bank loan 64,900 Total liabilities $ 70,000 Total Owner’s equity 130,000 Total liabilities and owner’s equity $200,000

  47. End of Chapter 3

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