FMGT 1100 Notes – Week 4 Ch.

Ch 3 – Measuring Business Income: The Adjusting Process:

Lecture 3-A

Review: What is a trial balance and what use is it?

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What is revenue?
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What is expense?
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Outline - Today’s Lecture will cover:

 Accrual accounting
 Revenue & expense recognition
 Adjusting entries

Distinguishing Accrual-Basis Accounting from Cash-Basis Accounting

Question: As a landlord, I collect rent from tenants, usually monthly. Imagine a tenant
paid me December, January, and February’s rent in one lump sum on December 1st,
2011. When I prepare my income statement, should my revenue for 2011 include this
lump sum rent payment?

A. In accrual-basis accounting, the accountant enters the transactions when the

business performs a service or incurs an expense, not when cash has been received
or paid.

1. Canada Revenue Agency (CRA) requires accrual-basis accounting for businesses.

2. Accrual-basis accounting provides more complete information.

3. In very rare cases, businesses use cash-basis accounting. In cash-basis

accounting, cash receipts are treated as revenues, and cash payments are treated
as expenses.

4. Three concepts used in accrual basis accounting are the accounting period, the
recognition criteria for revenues and expenses, and the time-period assumption.

B. The accounting period for most business is one year. At the end of this time, a
business measures and reports its income.

1. Some businesses use the calendar year—January 1 to December 31.

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2. Other businesses use a fiscal year with a year-end usually corresponding with a
low point in business activity.

3. Interim periods are less than a year. Monthly, quarterly or semiannual periods are
the most common. Monthly, quarterly financial statements are common.

Applying the Recognition Criteria for Revenues and Expenses

A. Revenue Recognition

1. The revenue recognition criteria states that revenues are recorded when earned.
Revenue is earned in most cases when the business has delivered a completed
good or service to the customer.

2. The amount of revenue recorded equals the cash value of the goods or services
transferred to the customer.

Teaching Tip
Revenue is earned when the business has delivered a completed good or service to
the customer or client. Students sometimes have difficulty grasping the concept that
revenue recognition is not related to cash. For example:

Dr. House performed three successful surgeries during the month of December. The
provincial insurance plan was billed a total of $30,000 on December 31. The doctor
didn’t receive payment for his services until February of the next year. According to
the revenue recognition criteria, when should the doctor recognize the revenue?
December or February? The answer is December, as that is when he performed the
surgeries (service).

B. Recognition criteria for expenses

1. The matching objective directs accountants to identify all expenses incurred

during the accounting period; measure the expenses and match the expenses with
the revenues that were generated by the expenses during that period.

2. Expenses (example: sales commission) with a natural link to revenues will be

matched against the revenue of a period. Other expenses (example: rent) that are
not easily linked with a particular sale will be identified with a particular time period.

C. Time-period assumption

1. The time-period assumption ensures that accounting information be reported at

regular intervals.

2. It defines the accounting period and interacts with the revenue- and expense-
recognition criteria to underlie the use of accruals.

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Sports Unlimited sells annual subscriptions for the 12 monthly magazines mailed to
customers each year. The company collects cash in advance and then mails out the
magazines to subscribers each month. Suppose the company collected $ 80,000 for
subscriptions for January to December. Apply the recognition criteria for revenues to
determine ( 1) when the company should record revenue for this situation and ( 2) the
amount of revenue the company should record for the January through March mailings.

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Because of these concepts, special journal entries, called adjusting entries, must be
recorded to ensure that all revenues and expenses for the accounting period have been
properly recorded.

Making Adjusting Entries

A. Adjusting entries assign revenues to the period in which they are earned and
expenses to the period in which they are incurred. They are needed to measure
properly the period’s income on the income statement and bring related asset and
liability accounts to correct balances for the balance sheet.

B. Adjusting entries can be divided into prepaids (deferrals) and accruals. Exhibit 3-7
below 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.

2. Accrual-type adjustments are needed when the cash transaction occurs after the
related expense or revenue is recorded.

NOTE: Cash is NEVER adjusted!!!!

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C. Adjusting entries can be divided into five categories: prepaid expenses,

amortization, 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 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 Expense XX
Prepaid Insurance XX

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On April 1, 2010, you prepaid six months of rent, for a total of $ 12,000. Give your
adjusting entry to record rent expense at April 30, 2010. Include the date of the entry and
an explanation. Then, using T- accounts, post to the two accounts involved, and show
their balances at April 30, 2010.

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2. Amortization of property, plant and equipment and intangible assets is the

allocation of the cost of a capital asset, except land, to expense over its useful life.

a. Amortization is similar to prepaid expenses in that an asset is recorded when

the plant or equipment is acquired. The asset is expensed as it is used. The
major difference is that prepaids usually expire within a year while plant and
equipment assets remain for a number of years.

Amortization Expense XX
Accumulated Amortization XX

b. As the asset is amortized, the asset’s book value declines. Book value is not
the same as market value. Instead of reducing the asset account, another
account, Accumulated Amortization, is used.

1) Accumulated amortization is a contra asset account; that is, an asset

account with a credit balance.

2) The carrying (book) value of the asset is determined by the following

formula:

Carrying (Book) value = Cost of asset – Accumulated amortization

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On May 1, your company paid cash of $ 27,000 for computers that are expected to
remain useful for three years. At the end of three years, the value of the computers is
expected to be zero. Make journal entries to record
( a) purchase of the computers on May 1 and
( b) amortization on May 31.
Include dates and explanations, and use the following accounts: Computer Equipment;
Accumulated Amortization— Computer Equipment; and Amortization Expense—
Computer Equipment.

Journal
ACCOUNT TITLES AND POST.
DATE EXPLANATIONS REF. DEBIT CREDIT
a.

b.

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Refer to the data above.

1. Using T- accounts, post the journal entries to the accounts listed above, and show their
balances at May 31.
2. What is the computer equipment’s carrying value at May 31?
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Review:
 Accrual accounting
 Revenue & expense recognition
 Adjusting entries (some)

Next Lecture:
 Adjusting entries (more)
 The adjusted trial balance
 More practice preparing financial statements

This concludes lecture 3-A. Ensure you complete any necessary homework
prior to the lab associated with this lecture.

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Lecture 3-B

Review: What is the primary difference between accrual accounting and cash-basis
accounting?:

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Outline - Today’s Lecture will cover:

 Adjusting entries (more)
 The adjusted trial balance
 More practice preparing financial statements

3. Accrued expenses are expenses that are incurred by the end of the period but
will not be paid until a later period. The adjusting entry records the expense and a
liability. Salaries, interest, and taxes are examples of accrued expenses.

Salary Expense XX
Salary Payable XX

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Suppose Ladner Environmental Services ( LES) borrowed $ 50,000 on October 1 by

signing a note payable to Royal Bank. LES’s interest expense for the remainder of the
year ( October through December) is $ 600.
1. Make LES’s adjusting entry to accrue interest expense at December 31. Date the entry
and include its explanation.
2. Using T- accounts, post to the two accounts affected by the adjustment.

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 FMGT 1100 Notes – Week 4 Ch. 3

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 a
revenue and a receivable. Interest and service revenue are examples of accrued
revenues

Interest Receivable XX
Interest Revenue XX

Teaching Tip
A revenue that has been earned but not yet received in cash must be accounted for with
an adjusting entry. The adjusting entry debits the receivable account and credits the
revenue account.

5. Unearned revenues arise when a business receives cash in one period but does
not earn all of it until the next 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

Teaching Tip
Students need to understand that unearned revenues represent an obligation to provide a
product or service in the future. At the end of an accounting period, an adjusting entry is
required to show the portion of the unearned revenue that has been earned during the
period and how much remains to be earned in the next period. The adjusting entry
decreases the liability with a debit, and increases a revenue account with a credit. It may
be helpful to trace the journal entry to the postings in the T-accounts.

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The Big Clipper Magazine collects cash from subscribers in advance and then mails the
magazines to subscribers over a one- year period. Give the adjusting entry that the
company makes to record the earning of $ 10,000 of Subscription Revenue that was
collected in advance.

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 FMGT 1100 Notes – Week 4 Ch. 3

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.

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Preparing an Adjusted Trial Balance

A. The adjusted trial balance is prepared after the adjusting entries have been
journalized and posted. (Exhibit 3-10 below shows the trial balance, adjustments, and
the adjusted trial balance in work sheet form for Ladner Environmental Services
(LES).)

B. The adjusted trial balance serves as the basis for the preparation of the financial
statements.

Prepare the Financial Statements from the Adjusted Trial Balance

A. The financial statements are prepared using the account balances found on the
adjusted trial balance.

B. The income statement is prepared first, followed by the statement of retained

earnings, and then the balance sheet. Note that the balance sheet is a financial
statement, the trial balance is not. DO NOT confuse the two!

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C. The essential features of all financial statements are:

1. The heading of the statement, which includes:

a. the name of the entity

b. the title of the statement

c. the date or period covered by the statement

2. The body of the statement

D. The following relationships exist among the financial statements:

1. Net income calculated from the income statement is used in preparing the
statement of owner’s equity.

2. The ending balance of the statement of owner’s equity is used in preparing the
balance sheet.

E. Accrual accounting provides some ethical challenges that cash accounting avoids.

1. Since expenses are not necessarily expensed when paid in accrual accounting,
management can exercise some discretion when recording expenses.

2. Estimates must be used when recording amortization, accrued revenues, and

accrued expenses. Unethical people can manipulate these estimates to reflect
favourably upon their company.

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Scissors Hair Stylists has begun the preparation of its adjusted trial balance as follows:

Year- end data: a. Supplies remaining on hand, $ 200

b. Amortization, $ 1,100
c. Accrued interest expense, $ 400
Complete the company’s adjusted trial balance. Identify each adjustment by its letter. To
save time, you may write your answer in the spaces provided on the adjusted trial
balance.

Refer to the data above. Compute Scissors Hair Stylists’ net income for the year ended
December 31, 2010.
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 FMGT 1100 Notes – Week 4 Ch. 3

Refer to the data above. Compute Scissors Hair Stylists’ total assets at December 31,
2010. Remember that Accumulated Amortization is a contra asset.
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Review:
 Adjusting entries (more)
 The adjusted trial balance
 More practice preparing financial statements

Next Lecture:
 Closing entries
 Completing the accounting cycle

This concludes lecture 3-B. Ensure you complete any necessary homework prior
to the lab associated with this lecture.

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