Chapter 3: The Matching Concept and the Adjusting Process

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Chapter 3 The Matching Concept and the Adjusting
Process
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I. Matching Concept

• Reporting revenues and expenses incurred to
  create the revenue are reported in the same
  accounting period.

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Question

• If rent for May is paid on June 1, in which month
  will be reported as rent expense?
• May?
• June?

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Answer

• It depends on whether the business is run in a
  cash basis or an accrual basis
• Accrual basis May
• Cash basis June
• Accrual basis revenues reported as earned
  expenses reported when incurred, e.g., matching
  the expenses to the revenues recorded.
• Cash basis revenues reported when received
  expenses reported when paid.

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Accrual Basis Business Applies for Loan and
Required to Provide List of Monthly Expenses

• Checkbook shows the following checks
• 375 rent
• 110 utilities
• 200 car payment
• 480 ½ year of car insurance
• 120 1 year of life insurance
• 20 paying for credit purchases last year

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How to Report?

• Rent ?
• Utilities ?
• Car Payment ?
• Car insurance ?
• Life insurance ?
• Credit Card ?

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Answer

• Rent Same as check
• Utilities Same as check
• Car Payment Same as check
• Car insurance 480/6 months 80/month
• Life insurance 120/12 10/month
• Credit Card Same as check
• Note If entire insurance payments are reported
  as monthly expenses, monthly expenses will be
  overstated.
• Illustration of the matching concept.

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Similar problem

• What if the business had received 10,000 loan,
  with principal and interest of 12 to be paid 12
  months after receipt of funds?
• Issue?

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Issue

• Not all business expenses for the month are paid
  monthly.
• The business must consider all expenses incurred
  for the month
• 10000(.12) 1200/year 120/month

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Similar problem

• What if the business made 100 in sales to
  customers but payment not received until 2 months
  later?
• Must show 200 revenue earned for the period even
  though unpaid.
• GAAP Net Income Revenues earned from sale of
  services during the period expenses incurred in
  providing those services.
• Match expenses against revenues they generate

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Accrual basis accounting requires adjusting
entries

• How much of the Accounts Receivables earned
  during the month?
• How much of the Supplies were used during the
  month?

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Exercise Net Income for Brick Layers Inc. for
the month of June

• 1200 Fees earned for a brick patio.
• 400 Bricks purchased on account to be paid in
  July.
• 20 2 cement bags purchased and paid in June
• 200 laborers pay at the end of the work.
• 600/moth Other monthly expenses paid for rent,
  utilities, insurance, etc.

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NET INCOME

• Revenues ?
• Expenses
• Bricks?
• Cement ?
• Wages ?
• Other expenses ?
• Net Profit ?

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NET INCOME

• Revenues ?
• Expenses
• Bricks?
• Cement ?
• Wages ?
• Other expenses ?
• Net Profit ?

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Net Income

• Revenues 1200
• Expenses
• Bricks 400
• Cement 20
• Wages 200
• Other expenses ¼ of 600 150
• Total Expenses 770
• Net Profit
  430

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II. Adjusting Entries

• Why?
• Accrual basis requires that we update accounting
  records so that all revenues earned and all
  expenses incurred are properly recorded.

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Types of adjusting entries

• Deferral cash transfers hands in current period
  in payment for performance in future periods.
• Deferred cash today for future performance
• Accruals Performance in current period and cash
  transfers hands in future periods.
• Accrue performance today for future cash

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Deferrals

• Deferred Expense
• When you pay for an item in advance (before it is
  actually used), e.g., a prepaid expense.
• 1st recorded as an asset.
• As the asset is used, adjusting entries reflect a
  transfer from the asset to an expense
• Supplies
• Prepaid insurance

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Supplies Recorded as an asset when purchased.

• As supplies are used each month, an adjusting
  entry is required to transfer the cost of
  supplies from an asset account to an expense
  account.

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Example

• On December 5, the business purchased 250 in
  supplies. On 12/31 the ending inventory in
  supplies was 50.
• Original entry
• Supplies250
• Cash..250
• Adjusting entry
• Supplies expense.. 200
• Supplies....200

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Prepaid insurance Recorded as an asset when
purchased.

• As the policy expires, each month the asset is
  being used up.
• So an adjusting entry is required to transfer the
  cost of insurance from an asset account to an
  expense account

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Example

• On December 1, the business purchased a 6-month
  insurance policy. On December 31, how do you
  record insurance?
• Original entry
• Prepaid insurance. 600
• Cash.. 600
• Adjusting entry
• Insurance Expense.. 100
• Prepaid Insurance100

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Deferred revenue

• Occurs when you get paid before you earn it,
  e.g., unearned revenues.
• Cash has been received for goods but as goods
  have not been delivered, the cash has not being
  earned.
• Records receipt of cash against a liability that
  reflects unearned revenues, e.g., a promise to
  deliver goods or services in the future.
• After delivery, revenues are earned, so a
  corresponding portion of the liability is
  transferred to revenue, e.g., revenue is
  recognized.

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Example

• On 11/2 the business received 3 months rent in
  advance or 2400. What is the entry at EOY?
• Original entry
• Cash ... 2400
• Unearned rent ..2400
• Adjusting entry
• Unearned rent1600
• Rent income 1600
• Note unearned liability in Balance Sheet
  earned revenue in Income Statement

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Accruals

• Accrued expense expenses incurred before
  payment.
• Assume electricity is paid on the 15th of the
  following month A daily utility expense is
  incurred but not paid. Others Accrued wages,
  accrued interest.
• Accrued revenues revenues are earned but not
  recorded. A business is not paid for services
  rendered during the month until the 10th of the
  following month. Other accrued interest on notes
  receivable.

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Example

• On Wednesday 12/31, the business owes 500 in
  wages. Payroll is Friday.
• Original entry None
• Adjusting entry
• Wages Expense.............500
• Wages Payable.500

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Example

• At EOY the business is owed 80 in interest.
• Original entry None
• Adjusting entry
• Interest receivable 80
• Interest Income..80

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Depreciation

• Applicable only to assets with a long life, e.g.,
  fixed assets
• While use of supplies is reflected by the
  quantity used, e.g., total supplies decreases as
  used, one building continues to be one building.
  However, as the equipment gets older, performance
  decreases.
• The decrease in performance or usefulness is
  known as depreciation.
• Decrease for the period is a function of useful
  life.
• Useful life is an artificially created of years
  the asset is expected to be useful.

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Recording Depreciation

• Depreciation expense reflects the periodic
  decrease in the building usefulness for the
  period being reported.
• Debit Depreciation Expense
• Credit Accumulated Depreciation
• Contra asset account
• Asset increases are denoted with debits
• Contra asset increases are denoted with credits
• Do not credit the original asset. Prices are
  reflected at their original cost.

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An analogy

• You need 4 tires. One set costs 200 with a life
  estimate of 20,000 miles. The other set costs
  300 with a life estimate of 40,000 miles. If you
  drive 10,000 miles/year and are keeping the car
  for at least 4 years, which is the best buy?

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Estimating Cost

• 200 set is estimated to last 20,000 miles or 2
  years. Thus, cost 100/year
• 300 set is estimated to last 40,000 miles or 4
  years. Thus cost 75/year.
• Upon purchase of 300 set, it is recorded as an
  asset. Every year, 75 is transferred to an
  expense account.
• Original entry
• Tires.300
• Cash..300
• Adjusting entry at EOY
• Depreciation expense..75
• Accumulated Depreciation.75

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Exercise

• An accrual business buys a building in an area
  where real estate is increasing at 6/year. You
  record depreciation.
• Why record depreciation when values are going up?
  

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Answer

• Depreciation is not related to the value of the
  asset.
• Depreciation is an estimate of the assets
  usefulness that has expired during the period.
• The original cost and the accumulated
  depreciation are reported in the Balance Sheet.
  Two separate accounts.

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Exercise Prepare journal entries from trial
balances

• Unadjusted/Adjusted
• Supplies 200/140
• Prepaid insurance 400/210
• Wages Payable 0/130
• Unearned revenue 100/30
• Fees earned 7200/7330
• Supplies expense 0/60
• Insurance expense 0/190

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Answer

• Supplies expense60
• Supplies60
• Expl Supplies at BOY200 EOY140
• Insurance expense.190
• Prepaid insurance.190
• Expl Prepaid insurance BOY400 EOY 210
• Wages Expense.130
• Wages Payable130
• Expl 130 wages accrued but not paid at EOY
• Unearned Revenue70
• Fees earned ..70
• Expln Unearned fees at EOY