CHAPTER 3

Measuring Business Income: The Adjusting Process

 

Chapter Overview

Chapter 3 introduces the student to the adjusting process. Cash and accrual accounting are illustrated and differentiated. The accounting period concept, the revenue and matching principles, and the time-period concept are explained. Prepaids, deferrals, and accruals are defined. The five categories of adjusting entries—prepaid expenses, depreciation, accrued expenses, accrued revenues, and unearned revenues—are illustrated and described in detail. The text provides examples of adjusting entries for prepaid rent, supplies, and depreciation of furniture. Book value is explained. The text then provides examples of accrued salaries, accrued service revenue, and unearned service revenue. A comparison of the timing of both prepaids and accruals along with a summary of the adjusting process concludes the discussion of adjusting entries.

The last part of the chapter focuses on the financial statements. Students learn how to prepare an adjusted trail balance and use it to prepare the financial statements. The relationship among the financial statements is emphasized. Following a discussion of ethical issues in accrual accounting, Decision Guidelines help students through the adjusting process. Decision Guidelines feature important questions about the adjusting process and the adjusted trial balance. A summary problem reviews adjusting entries, the adjusted trial balance, and preparation of the financial statements. An appendix covers an alternate way to record prepaid expenses and unearned revenues—directly into an income statement account.

Learning Objectives

After studying Chapter 3, your students should be able to:
  1. Distinguish accrual-basis accounting from cash-basis accounting
  2. Apply the revenue and matching principles
  3. Make adjusting entries at the end of the accounting period
  4. Prepare an adjusted trial balance
  5. Prepare the financial statements from the adjusted trial balance

 

 

Chapter Outline

Objective 1: Distinguish accrual-basis accounting from cash-basis accounting
  1. To measure income, businesses must apply accounting principles and concepts, such as accrual-basis accounting, the accounting period, the revenue principle, and the matching principle.
    1. In accrual-basis accounting, the accountant enters the transactions when the business performs a service or incurs an expense.

      2. 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 accrual-basis and cash-basis of accounting.)

      b. The accrual-basis is the more correct and common method used.

    2. 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.

B. The accounting period for most business 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
  1. Three accounting principles and concepts underlie the use of accrual-basis 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.)
    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.

B. 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 at the end of the accounting period
  1. 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 periods 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 in which they are earned and expenses to the period in which 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 the accrual-basis but never required when using the cash-basis.

B. Adjusting entries can be divided into prepaids (deferrals) and accruals. Exhibit 3-7 illustrates the prepaid- and accrual-type adjustments.
    1. Prepaid-type 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.
    2. Accrual-type 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.

C. Adjusting entries can be further divided into five categories: prepaid expenses, depreciation, accrued expenses, accrued revenues, and unearned revenues.

1. Prepaid expenses (or deferrals) 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 would increase the asset and decrease cash.

Prepaid Insurance (or Supplies) XX

Cash XX

b. 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. 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 XX

b. 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 with its companion account on the financial statements.

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 XX

Salary Payable XX

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 received). Interest and service revenue are examples of accrued revenues.

Interest Receivable XX

Interest Revenue XX

5. 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 would increase cash and increase a liability.

Cash XX

Unearned Revenue XX

b. The adjusting entry records the part of the unearned revenue that has been earned.

Unearned Revenue XX

Service Revenue XX

D. 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 summarizes the adjusting entries and Exhibit 3-9 illustrates all of the adjusting entries and T-accounts for Gay Gillen eTravel.)

 

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