Income measurement

and Adjusting Entries

BBA Honors and Emphasis Program
Kathmandu University School of
Management (KUSOM)
Recognition and Measurement
Recognition: formally I know I
recording an item in the need to
financial statements of record
an entity this...

...but at
current value Measurement:
or historical quantification of the
cost? economic effects of
the item on the entity

LO1
Recognition and Measurement
 Cash vs. Accrual Basis
Cash basis: revenues and expenses are
recorded only when cash is received or paid

Accrual basis: revenues are recognized when

earned; expenses are recognized when incurred

LO2
 Cash basis Accrual basis
statement statement
Statement of Income
Cash Flows Statement

Cash flows from Net income:

operating activities: $ 7,000
$(4,000)
What accounts for
the difference?
For the following situations, indicate the date on
which revenue would be recognized, assuming
the accrual basis of accounting.
__________ a. On June 10, a customer orders a
product over the phone. The product is shipped
to the customer on June 14, and the customer
pays the amount owed on July 10.
__________ b. On March 15, a law firm agrees to
draft a legal document for a client. The document
is completed and delivered to the client on April
5, and the client pays the amount owed on May 2.
__________ c. A homeowner signs a contract on
August 6 to have a company install a central air
conditioning system. The work is completed on
August 30, and the homeowner pays the amount
owed on September 25.
 Revenue Recognition Principle
Revenue is recognized when realized and
earned—usually at time of sale

Exceptions:
 Long-term contracts
 Franchises
 Commodities
 Installment sales
 Rent and interest
LO3
 Matching Principle
Match expenses with associated revenues

Indirectly over Simultaneously

Directly
period they upon their
provide benefits acquisition

e.g., Inventory e.g., Buildings e.g., Utilities

LO4
 The relationships among
costs, assets, and expenses
 Expense Recognition
Balance Sheet Income Statement
ASSETS: EXPENSES:
Inventory when sold Cost of goods sold

Supplies expense
Supplies
as used Insurance expense
Prepaid assets Rent expense

PP&E Depreciation expense

over period they
Intangibles Amortization expense
provide
l benefits
Other expenses
(as incurred)
Types of Adjusting Entries
Deferred Accrued
expense liability
RECOGNIZE REVENUE
OR EXPENSES
BEFORE OR AFTER
CASH IS EXCHANGED

Accrued Deferred
asset revenue
LO5
 Deferred Expense
Cash paid before expense is incurred
 Examples:
• Prepaid rent
• Prepaid insurance
• Office supplies
• Property and equipment

 Costs are initially recorded as assets and

allocated to expenses in future periods
Deferred Expense Example #1
Prepay insurance for one year on September 1
Initial journal entry:
9/1 Prepaid Insurance 2,400
Cash 2,400
Monthly adjusting journal entry:
9/30 Insurance Expense 200
Prepaid Insurance 200
($2,400 annual × 1/12 = $200 per month for 12 months)
Deferred Expense Example #2
Purchase new store fixtures on January 1 for $5,000.
Estimated useful life is 5 years (60 months); estimated
salvage value is $500
Initial journal entry:
1/1 Store fixtures 5,000
Cash 5,000
Monthly adjusting journal entry:
1/31 Depreciation Expense 75
Accumulated Depreciation 75
($5,000 – $500) × 1/60 = $75 per month for 60 months)
Calculation of
Depreciation
 Practice Exercise 4-5
Somerville Corp. purchases office supplies
once a month and prepares monthly financial
statements. The asset account Office Supplies
on Hand has a balance of $1,450 on May 1.
Purchases of supplies during May amount to
$1,100. Supplies on hand at May 31 amount to
$920.
Prepare the necessary adjusting entry on
Somerville’s books on May 31. What will be the
effect on net income for May if this entry is not
recorded?
 Deferred Revenue
Cash received before revenue is earned
 Examples:
• Insurance collected in advance
• Subscriptions collected in advance
• Gift certificates
 Receipts are initially recorded as liabilities (unearned
or refundable receipts) and recorded as revenues in
future periods when earned
 Deferred Revenue Example
Received $2,400 for an insurance policy in advance on
September 1

Initial journal entry:

9/1 Cash 2,400
Insurance Collected in Advance 2,400
Monthly adjusting journal entry:
9/30 Insurance Collected in Advance 200
Insurance Revenue 200
($2,400 annual × 1/12 = $200 per month for 12 months)
 Exercise 4-12
Wolfe & Wolfe collected $9,000 from a
customer on April 1 and agreed to provide
legal services during the next three months.
Wolfe & Wolfe expects to provide an equal
amount of services each month.
Required
1. Prepare the journal entry for the receipt of
the customer deposit on April 1.
2. Prepare the adjusting entry on April 30.
3. What will be the effect on net income for
April if the entry in (2) is not recorded?
 Accrued Liability
Expense incurred before cash is paid
 Examples:
• Payroll
• Taxes
• Interest
 Record expense (and corresponding liability) in
period incurred; pay for it in a future period
 No cash flow on recording, only when paid
Accrued Liability Example #1
Pay biweekly wages of $280,000

At end of month, between pay periods:

Wages Expense 40,000
Wages Payable 40,000
Next payday:
Wages Payable 40,000
Wages Expense 240,000
Cash 280,000
Accrued Liability Example #2
On March 1, assume a 9%, 90-day, $20,000
loan is taken out with a bank

Initial journal entry:

3/1 Cash 20,000
To Notes Payable 20,000
Monthly adjusting journal entry:
3/31 Interest Expense 150
To Interest Payable 150
($20,000 principal × 9% × 3/12 = $450 for 3 months or
$450/3 = $150 per month)
Accrued Liability Example #2
(continued)
To record payment of a 9%, 90-day, $20,000 loan with
interest due on May 30

5/30 Interest Payable 300

Interest Expense 150
Notes Payable 20,000
To Cash 20,450
 Exercise 4-16
Billings Company takes out a 12%, 90-day,
$100,000 loan with First National Bank on
March 1, 2014.
Required:
1. Prepare the journal entry on March 1, 2014.
2. Prepare the adjusting entries for the months
of March and April 2014.
3. Prepare the entry on May 30, 2014, when
Billings repays the principal and interest to
First National.
 Accrued Asset
Revenue earned before cash is received
 Examples:
• Rent
• Interest
 Record revenue (and corresponding receivable) in
period earned; receive payment in a future period
 Accrued Asset Example
Rent payment (for tenant) of $2,500 due
within first 10 days of month
First day of the month:
Rent Receivable 2,500
To Rent Revenue 2,500
Upon receipt of cash:
Cash 2,500
To Rent Receivable 2,500
 Exercise 4-20
On June 1, 2014, MicroTel Enterprises lends
$60,000 to MaxiDriver Inc. The loan will be
repaid in 60 days with interest at 10%.
Required
1. Prepare the journal entry on MicroTel’s
books on June 1, 2014.
2. Prepare the adjusting entry on MicroTel’s
books on June 30, 2014.
3. Prepare the entry on MicroTel’s books on
July 31, 2014, when MaxiDriver repays the
principaland interest.
 Adjusting Entry Summary
Examples:
 Deferred Expense
cash paid before expense is incurred
 Deferred Revenue
cash received before revenue is earned
 Accrued Liability
expense incurred before cash is paid
 Accrued Asset
revenue is earned before cash is received
 Problem 4-1 Adjusting Entries
Kretz Corporation prepares monthly financial statements
and therefore adjusts its accounts at the end of every
month. The following information is available for March
2014:
a.Kretz Corporation takes out a 90-day, 8%, $15,000 note
on March 1, 2014, with interest and principal to be paid at
maturity.
b.The asset account Office Supplies on Hand has a
balance of $1,280 on March 1, 2014. During March, Kretz
adds $750 to the account for purchases during the period.
A count of the supplies on hand at the end of March
indicates a balance of $1,370.
c.The company purchased office equipment last year for
$62,600. The equipment has an estimated useful life of six
years and an estimated salvage value of $5,000.
 CONTD..Problem 4-1 Adjusting Entries
d. The company’s plant operates seven days per week with a
daily payroll of $950. Wage earners are paid every Sunday.
The last day of the month is Saturday, March 31.
e. The company rented an idle warehouse to a neighboring
business on February 1, 2014, at a rate of $2,500 per month.
On this date, Kretz Corporation credited Rent Collected in
Advance for six months’ rent received in advance.
f. On March 1, 2014, Kretz Corporation credited a liability
account, Customer Deposits, for $4,800. This sum represents
an amount that a customer paid in advance and that Kretz will
earn evenly over a four-month period.
g. Based on its income for the month, Kretz Corporation
estimates that federal income taxes for March amount to
$3,900.
Required: For each of the preceding situations, prepare in
general journal form the appropriate adjusting entry to be
recorded on March 31, 2014.
Content after mid-term
exam
Steps in the Accounting Cycle
1. Collect and
7. Close the analyze info
2. Journalize
accounts transactions

6. Record and
post adjusting 3. Post
entries transactions to
general ledger
5. Prepare
financial 4. Prepare
statements work sheet
LO6
 The Closing Process
Closing entries are made at the end of an
accounting period.
Purpose:
 To return the balance of revenue, expense,
and dividend accounts to zero to begin the
next period
 To transfer the net income of the period to
Retained Earnings
Real and Nominal Accounts
Two types of accounts appear on an adjusted
trial balance.
1.Balance sheet accounts are called real
accounts because they are permanent in nature.
Real accounts are never closed and the balance
in each of them is carried over from one period
to the next.

2.Revenue, expense, and dividend accounts are

temporary or nominal accounts. The balances in
the income statement accounts and the
Dividends account are closed and not carried
forward from one accounting period to the next.
 Nominal Accounts
Revenues Expenses
Close to Normal Normal Close to
Income balance balance Income
Summary Summary
$ XX $ XX $ XX $ XX

Dividends Zero out

Normal Close to
nominal accounts
balance Retained
Earnings
to start accumulation
of next period’s
$ XX $ XX results
LO7
 Closing entries
An account with a debit balance is closed by
crediting the account for the amount of the
balance i.e. Expense accounts are credited to
close them.

An account with a credit balance is closed by

debiting the account for the amount of the
balance i.e. revenue accounts are debited in
the closing process.
 Closing Process
A temporary holding account is used called Income Summary to
facilitate the closing process.
1.A single entry is made to close all of the revenue accounts. The
total amount debited to the revenue accounts is credited to Income
Summary.
2.Similarly, a single entry is made to close all of the expense
accounts, and the offsetting debit is made to Income Summary.
3.After the revenue and expense accounts are closed, Income
Summary has a credit balance if revenues exceed expenses. The
credit balance in Income Summary is closed by debiting the account
and crediting Retained Earnings for the same amount. The net result
of the process is that all of the revenues less expenses (i.e., net
income) have been transferred to Retained Earnings.
4.The Dividends account is closed directly to Retained Earnings.
Because dividends are not an expense, the Dividends account is not
closed first to the Income Summary account. A credit is made to
close the Dividends account with an offsetting debit to Retained
Earnings.
 Closing Entries
Income Summary
$XX $XX
from expense from revenue
accounts accounts

(Net loss) or net income

closed to Retained Earnings
 Appendix
Accounting Tools:
Work Sheets
Unadjusted Trial Balance Columns

Begin by filling in the

trial balance

accounts and amounts

LO8
The Adjusting Entries Columns

Make adjustments;
formal journal
entries
are prepared later
 Ad
ad d o
ac jus r s
co tm ub
un e tr
t b nts act
al fo
an r
ce a d
s jus
te
d
Adjusted Trial Balance Columns
The Income Statement Columns

Extend revenue and expense

account balances to the
income statement
The Balance Sheet Columns

Extend asset, liability, and

equity accounts to the
balance sheet
End of Chapter 4