CHAPTER 3. Measuring Business Income. The Adjusting Process

Horngren’s Accounting
Volume One, Eleventh Canadian Edition
Chapter 3
Measuring Business Income:
The Adjusting Process
Copyright © 2020 Pearson Canada Inc. 3-1

Learning Objective 1
Apply the recognition criteria for revenues and expenses
• When does a sale really happen?

• When do we record an expense?

The Accounting Cycle

The Time-Period Assumption
• Ensures that accounting information is reported at
regular intervals
Interacts with the revenue-

Requires that income be
and expense-recognition
measured accurately each
criteria, and the matching
period
objective for expenses

The Accounting Period
• Businesses need periodic (annual) reports on their
progress
• Fiscal year ends do not need to be the same as the
calendar year end
• Interim statements can be presented to support decision
making:
– Monthly
– Quarterly
– Semi-annually

Recognition Criteria for Revenues
• Revenue recognition states that revenue should be
recognized when it is earned:
– Goods delivered or services completed; or
– Contractual agreements have been met
• Recognition criteria for revenues tell accountants:

– When to record revenue (it has been earned)
– The amount of revenue to record
• Record revenue equal to the cash value (not cash paid) of

the goods or services (remember payment-in-kind)

Recognition Criteria for Expenses (1 of 2)
Matching objective:
a. Match expenses incurred with revenues earned during
the accounting period (i.e. the cost of a product that has
been sold); OR
b. Match expenses incurred with appropriate time period
(i.e. rent expense relates to a particular month)
Definition of Expenses: cost of assets and services
consumed when earning revenue.
• To match expenses against revenues means to subtract
the related expenses from the revenue to compute net
income (or net loss)
Recognition Criteria for Expenses (2 of 2)
• Matching objective – The criteria to help us determine
when to recognize expenses:
– Identify all expenses incurred during the accounting period
– Measure the expenses
– Match the expenses against the revenues earned during that
period
• Some expenses cannot be easily matched to revenues

– Rent and utilities are examples
– These types of expenses should be matched to the time period
that they relate to

Distinguish accrual-basis accounting from cash-basis
accounting
• Why can't we wait to record transactions until the cash

comes in or the cash goes out?

Accrual-Basis Accounting Versus
Cash-Basis Accounting
• Accrual-basis accounting records the effect of
every business transaction as it occurs, no matter
when the cash payments occur
• Cash-basis accounting records transactions only
when cash receipts and cash payments occur
Records revenues when they are earned
Accrual
Basis Records expenses when they are incurred
Records cash receipts as revenue

Cash Basis
Records cash payments as expenses
Copyright © 2020 Pearson Canada Inc. 3 - 10

Prepare adjusting entries
• What is the adjusting process, and why is it important?

Adjusting the Accounts
• Accrual-basis accounting requires adjusting entries at the
end of the period in order to produce correct balances for
the financial statements
• This is the process used to deal with the disconnect
between transaction timing and actual cash flows
• Adjusting entries:
1. Measure properly the period’s income on the income statement:
 Assign revenues to the period in which they are earned
 Assign expenses to the period in which they are incurred
2. Update the asset and liability accounts

Types of Adjusting Entries
• There are two main types of adjusting entries:
– Prepaid (deferrals) – cash is paid or received before the related
expense or revenue is recorded
– Accruals – record the expense or revenue before the related cash
is paid or received
• These types can be divided into five categories:

Prepaid Expenses
• Prepaid expenses are advance payments of the expense
• They are assets since they represent a potential future
economic benefit
• This means that cash was PAID prior to the good or
service being delivered
– Examples include: prepaid rent, prepaid insurance, and supplies

Prepaid Insurance Example
• Insurance policies are usually PAID for in advance
• On May 1, 2019, HEC purchases an annual insurance
policy for $3,600; the journal entry would be:
Prepaid Insurance 3,600 Blank
Cash Blank 3,600
To record payment for an annual policy. Blank Blank
• After one month has passed, the adjusting entry on May

31, 2019 is:
Insurance Expense 300 Blank
Prepaid Insurance Blank 300
To record insurance expense for the month. Blank Blank

Prepaid Insurance Example, posting
ASSETS EXPENSES
Prepaid Insurance Insurance Expense
May 1 3,600 May 31 300 May 31 300 Blank Blank
Bal. 3,300 Blank Blank Bal. 300 Blank Blank

Supplies Example
• On May 2, 2019, HEC purchases supplies for $1,500 cash
• The journal entry would be:
Supplies 1,500 Blank
Cash Blank 1,500
To record supplies purchased. Blank Blank
• On May 31, 2019, a physical count of the supplies

indicated that $1,000 remained; the adjusting entry would
reduce the Supplies asset by $500:
Supplies Expense 500 Blank
Supplies Blank 500
To record supplies used. Blank Blank

Supplies Example, posting
ASSETS EXPENSES
Office Supplies Supplies Expense
May 2 1,500 May 31 500 May 31 500 Blank Blank
Bal. 1,000 Blank Blank Bal. 500 Blank Blank

Amortization of Property, Plant, and
Equipment, and Intangible Assets
• Property, plant, and equipment (PPE) are identifiable
tangible capital assets (land, buildings, furniture, vehicles,
machinery, and equipment)
• Amortization (depreciation) defined:
– The process of allocating the cost of property, plant, and
equipment (PPE), less its residual value, to an expense account
over its estimated useful life
• All these tangible capital assets except land decline in

usefulness as they age; this decline is an expense to the
business.
• Intangible assets, such as patents and trademarks, are
amortized over the intangible asset’ s useful life
Amortization Example (1 of 2)
• On May 3, 2019, HEC purchases furniture for $45,000 with
an expected life of 5 years
• The journal entry, to record the purchase:
Furniture 45,000 Blank

Cash Blank 45,000
To record the purchase of furniture. Blank Blank
ASSETS
Furniture
May 3 45,000
Bal. 45,000 Blank Blank

Amortization Example (2 of 2)
• A portion of the furniture’ s cost is transferred from the
asset account to Amortization Expense each period the
asset is used; after one month, the May 31, 2019 entry is:
Amortization Expense – Furniture 750 Blank
Accumulated Amortization – Furniture Blank 750
To record the amortization of furniture. Blank Blank
• Straight-line Amortization is used to record monthly

amortization expense on furniture:
• $45,000 ÷5 years = $9,000 per year
• $9,000 ÷ 12 months = $750 per month
• Accumulated Amortization – Furniture is known as a

contra account
Contra Account
• A contra account has:
– a companion account
– a normal balance opposite that of the companion account
• Accumulated Amortization is a contra account to property,

plant, and equipment assets
• Used to show the cumulative sum of all amortization
expense from the date of acquiring the asset
• It has a normal credit balance

Amortization, Example
• After posting the amortization, the related accounts are as
follows:
CONTRA ASSET EXPENSES
ASSETS Accumulated Amortization Amortization Expense—
Furniture —Furniture Furniture
May 31 750 Blank Blank

Blank Blank
May 3 45,000 Blank Blank May 31 750
Bal. 750 Blank Blank

Blank Blank
Bal. 45,000 Blank Blank Bal. 750
• The resulting value of the Furniture asset, after deducting

the Accumulated Amortization, is $44,250
• This is known at the asset’s Book Value:
Furniture $45,000
Less: Accumulated Amortization—Furniture 750
Furniture, net $44,250

Partial Balance Sheet of HEC

Unearned Revenues, or Deferred
Revenue
• Unearned revenue defined:
– Receiving payment in advance from customers prior to
delivering the product or providing the service
• Unearned revenue is a LIABILITY, as it represents the

entity’ s obligation to deliver a good or service
– The company owes a product or service to the customer or the
money back
• Only when the service is provided or product delivered is

the revenue earned

Unearned Revenue Example (1 of 3)
• HEC receives a cash advance of $3,000 on May 20, 2019
from a customer for a 30 day project
• The journal entry is:
May 20 Cash 3,000 Blank
Blank Unearned Service Revenue Blank 3,000
Blank Received revenue in advance. Blank Blank

• Adjusting the unearned revenue account is required, to
reflect revenues that are earned
• During the last 10 days of the month—May 21 through
May 31—HEC will have earned one-third (10 days divided
by April’s total 30 days) of the $3,000, or $1,000
• The adjusting entry is:
May 31 Unearned Service Revenue 1,000 Blank
Blank Service Revenue Blank 1,000
Blank To record service revenue earned and paid Blank Blank
from the advance ($3,000 × ⅓).

LIABILITIES REVENUES
Unearned Service Revenue Service Revenue
May 31 1,000 May 20 3,000 Blank Blank Blank 24,000
Blank Blank Bal. 2,000 Blank Blank May 31 1,500
Blank Blank May 31 1,000
Blank Blank Bal. 26,500
Correct liability Total accounted Correct revenue

amount, $2,000 for, $3,000 amount, $1,000

Accrued Expenses
• Accruals are the recording of the expense or revenue
before the related cash is paid or received
• Accrued expenses defined: An expense that the business
has incurred but has not yet paid
• Accrued expenses always create a liability

Accrued Expense Example:
Salaries Expense (1 of 3)
• HEC pays its two employees a bi-monthly salary of $4,000
in total on the 15th and on the last day of the month
• The employees are paid on May 15, but May 31 is a
Saturday: thus employees will receive their pay cheques
on Monday, June 2
• Match the salaries expense to the period with a journal
entry on May 31 to make the accrual:
May 31 Salaries Expense 4,000 Blank
Blank Salaries Payable Blank 4,000
Blank To accrue salaries expense. Blank Blank

Accrued Expense Example: Salaries
Expense (2 of 3)
• After posting, the Salaries Expense and Salaries Payable
accounts contain the complete salary information for the
month of May
• The payment on June 2 does not affect May or June
expenses because the May expense was recorded on
May 15 and May 31
EXPENSES LIABILITIES
Salaries Expense Salaries Payable
May 15 4,000 Blank Blank Blank Blank May 31 4,000
May 31 4,000 Blank Blank Blank Blank Bal. 4,000

Accrued Expense Example: Salaries
Expense (3 of 3)
• Future Payment of Accrued Salaries:
• HEC will record the payment of this liability on Monday,
June 2, as follows:
June 2 Salaries Payable 4,000 Blank

Blank Cash Blank 4,000
Blank To record the payment of the salary payable. Blank Blank

Accrued Revenues
• Accrued revenues defined:
– Revenue that has been earned but not yet invoiced or collected
• Businesses often earn revenue before they collect the

cash
– Since it is earned, it should be recognized

Accrued Revenue Example (1 of 2)
• HEC is hired on May 15 to provide monthly services for
$3,000 per month, with the first payment to be received on
June 15. Service is provided from May 15 to May 30.
• The adjusting entry on May 30 to record two weeks of
revenue is:
May 31 Accounts Receivable 1,500 Blank

Blank Service Revenue Blank 1,500
Blank To accrue service revenue ($3,000 × ½). Blank Blank
• Adjusting for accrued revenues illustrates the concept of

revenue recognition
Accrued Revenue Example (2 of 2)
• All accrued revenues are accounted for similarly:
– Debit a receivable account and credit a revenue account
ASSETS REVENUES
Accounts Receivable Service Revenue
Bal.lan 14,000 Blank Blank Blank Blank Bal.Blk 24,000
May 31 1,500 Blank Blank Blank Blank May 31 1,000
May 31 1,500
Blank Blank Bal. 26,500
• Two rules to remember about adjusting entries:
1. Adjusting entries never involve the Cash account.
2. Adjusting entries either
a) increase a revenue account (credit revenue) or
b) increase an expense account (debit expense)
Summary of Adjusting Entries
Type of Account
Blank Category of Adjusting Entry Debited Credited
Prepaid-type Prepaid expense Expense Asset
Blank Amortization Expense Contra asset
Blank Unearned revenue Liability Revenue
Accrual-type Accrued expense Expense Liability
Blank Accrued revenue Asset Revenue

Summary of Adjusting Entries (2 of 3)

Summary of Adjusting Entries (3 of 3)

Prepare an adjusted trial balance
• How do we get the accounting records ready to prepare

the financial statements?

The Adjusted Trial Balance
• The adjusting process starts with the unadjusted trial
balance
• Adjusting entries are journalized and posted to the
ledgers
• The adjusted trial balance is prepared, which serves as a
basis for the preparation of the financial statements

Prepare the financial statements from the adjusted trial
balance
• Remind me: How do we prepare the financial statements?

Preparing the Financial Statements
from the Adjusted Trial Balance
• The financial statements should be prepared in the
following order:
– Income statement
– Statement of owner’s equity
– Balance sheet
• The essential features of all financial statements:

– Heading - name of the entity, title of the statement, and date or
period covered
– Body of the statement

Relationships among the Three
Financial Statements (1 of 3)
• The income statement reports net income or net loss,
calculated by subtracting expenses from revenues
– Because revenues and expenses are owner’s equity accounts,
their net figure is then transferred to the statement of owner’s
equity
• Capital is a balance sheet account, so the ending balance

in the statement of owner’s equity is transferred to the
balance sheet



Ethical Considerations in Accrual
Accounting
• Only with honest and complete information, including
accounting data, can people expect to make wise
decisions
• Accrual accounting allows for judgment and creates the
potential for bias and manipulation
• A few examples of potential bias:
– Overstating revenues (not yet earned)
– Understating expenses (deferring expenses to a future period)
– Extending the useful life of a capital asset to reduce amortization
expenses

Describe the adjusting-process implications of
International Financial Reporting Standards (IFRS)
• How does IFRS apply to adjusting entries?

Adjusting-Process Implications of International
Financial Reporting Standards (IFRS)

Learning Objective A1 (Appendix A)
Account for a prepaid expense recorded initially as an
expense
• Is there another way to record prepaids?

Prepaid Expenses Recorded Initially as
an Expense (1 of 3)
• Prepaid Insurance, Prepaid Rent, Prepaid Advertising, and
Prepaid Legal Cost are prepaid expenses
• Supplies that will be used up in the current period or within
one year are also accounted for as prepaids
• Earlier, we looked at situations where a business prepays
an expense, debits an asset account and later, as it is
used up, debits an expense account
• What if the business prepaid an expense, but recorded the
entire amount as an expense at the time of payment?
– We must prepare the adjusting entry in a different manner

an Expense (2 of 3)
• On August 1, 2019 a business paid $3,600 for an annual
insurance policy; the August 1 entry to record the payment is:
Aug. 1 Advertising Expense 4,800 Blank
Blank Cash Blank 4,800
Blank Paid for a 12-month advertising contract. Blank Blank
• The year-end is December 31; five months have passed,

but seven months of value remain in the policy
• The adjusting entry on December 31 is:
Blank Adjusting Entries Blank Blank
Dec. 31 Prepaid Advertising 2,800 Blank
Blank Advertising Expense Blank 2,800
Blank Prepaid advertising of $2,800 ($4,800 × 7/12). Blank Blank

an Expense (3 of 3)
• At December 31, only five months’ prepayment
has expired, leaving seven months still prepaid
ASSETS EXPENSES
Prepaid Advertising Advertising Expense
Dec. 31 Adj. 2,800 Blank Blank Aug. 1 Payment 4,800 Dec. 31 Adj. 2,800
Dec. 31 Bal. 2,800 Blank Blank Dec. 31 Bal. 2,000 Blank Blank
7 months remaining 5 months expired
Correct asset Total accounted Correct expense


Learning Objective A2 (Appendix A)
Account for an unearned (deferred) revenue recorded
initially as a revenue
• Is there another way to record unearned revenues?

Unearned (Deferred) Revenue Initially
Recorded as a Revenue (1 of 3)
• Unearned (deferred) revenues arise when a business
collects cash in advance of earning the revenue
• The recognition of revenue is deferred until earned
• Unearned revenues are liabilities
• Earlier, we looked at situations where a liability was
recognized when the cash was received for unearned
revenue
• What if the business recorded the transaction as revenue
at the time the cash was received?
– We must prepare the adjusting entry in a different manner

• On October 1, 2019 a consulting firm records as consulting revenue the receipt
of $18,000 cash for revenue to be earned evenly over nine months; the journal
entry on October 1 to record the cash receipt is:
Oct. 1 Cash 18,000 Blank
Blank Consulting Revenue Blank 18,000
Blank Received revenue to be earned over nine months. Blank Blank
• The year-end is December 31; three months of consulting service has

been provided, thus the revenue has been earned and should be
recognized
• However, six months of the nine is unearned and should be adjusted
• The adjusting entry on December 31 is:
Blank Adjusting Entries Blank Blank
Dec. Consulting Revenue 12,000 Blank
31
Blank Unearned Consulting Revenue Blank 12,000
Blank Adjust for consulting revenue still to be earned. Blank Blank
• At December 31, the adjusting entry moves the unearned portion
into the liability account because the business still owes consulting
service to the client during January to June of the following year
LIABILITIES REVENUE
Unearned Consulting Revenue Consulting Revenue
Blank Blank Dec. 31 Adj. 12,000 Dec. 31 Adj. 12,000 Oct. 1 Receipt 18,000
Blank Blank Dec. 31 Bal. 12,000 Blank Blank Dec. 31 Bal. 6,000
6 months of the balance is still

3 months of the balance is earned
unearned
Correct liability Total accounted Correct revenue


CHAPTER 3. Measuring Business Income. The Adjusting Process

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CHAPTER 3. Measuring Business Income. The Adjusting Process

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Horngren’s Accounting

Volume One, Eleventh Canadian Edition

Copyright © 2020 Pearson Canada Inc. 3-1

• When does a sale really happen?

Copyright © 2020 Pearson Canada Inc. 3-2

Copyright © 2020 Pearson Canada Inc. 3-3

Interacts with the revenue-

Copyright © 2020 Pearson Canada Inc. 3-4

Copyright © 2020 Pearson Canada Inc. 3-5

• Recognition criteria for revenues tell accountants:

• Record revenue equal to the cash value (not cash paid) of

Copyright © 2020 Pearson Canada Inc. 3-6

• Some expenses cannot be easily matched to revenues

Copyright © 2020 Pearson Canada Inc. 3-8

• Why can't we wait to record transactions until the cash

Copyright © 2020 Pearson Canada Inc. 3-9

Records cash receipts as revenue

Copyright © 2020 Pearson Canada Inc. 3 - 10

• What is the adjusting process, and why is it important?

Copyright © 2020 Pearson Canada Inc. 3 - 11

Copyright © 2020 Pearson Canada Inc. 3 - 12

• These types can be divided into five categories:

Copyright © 2020 Pearson Canada Inc. 3 - 13

Copyright © 2020 Pearson Canada Inc. 3 - 14

• After one month has passed, the adjusting entry on May

Copyright © 2020 Pearson Canada Inc. 3 - 15

Copyright © 2020 Pearson Canada Inc. 3 - 16

• On May 31, 2019, a physical count of the supplies

Copyright © 2020 Pearson Canada Inc. 3 - 17

Copyright © 2020 Pearson Canada Inc. 3 - 18

• All these tangible capital assets except land decline in

Furniture 45,000 Blank

Copyright © 2020 Pearson Canada Inc. 3 - 20

• Straight-line Amortization is used to record monthly

• Accumulated Amortization – Furniture is known as a

• Accumulated Amortization is a contra account to property,

Copyright © 2020 Pearson Canada Inc. 3 - 22

May 31 750 Blank Blank

May 3 45,000 Blank Blank May 31 750

Bal. 750 Blank Blank

Bal. 45,000 Blank Blank Bal. 750

• The resulting value of the Furniture asset, after deducting

Copyright © 2020 Pearson Canada Inc. 3 - 23

Copyright © 2020 Pearson Canada Inc. 3 - 24

• Unearned revenue is a LIABILITY, as it represents the

• Only when the service is provided or product delivered is

Copyright © 2020 Pearson Canada Inc. 3 - 25

Copyright © 2020 Pearson Canada Inc. 3 - 26

Copyright © 2020 Pearson Canada Inc. 3 - 27

Correct liability Total accounted Correct revenue

Copyright © 2020 Pearson Canada Inc. 3 - 28

Copyright © 2020 Pearson Canada Inc. 3 - 29

Copyright © 2020 Pearson Canada Inc. 3 - 30

Copyright © 2020 Pearson Canada Inc. 3 - 31

June 2 Salaries Payable 4,000 Blank

Copyright © 2020 Pearson Canada Inc. 3 - 32

• Businesses often earn revenue before they collect the

Copyright © 2020 Pearson Canada Inc. 3 - 33

May 31 Accounts Receivable 1,500 Blank

• Adjusting for accrued revenues illustrates the concept of

Copyright © 2020 Pearson Canada Inc. 3 - 36

Copyright © 2020 Pearson Canada Inc. 3 - 37

Copyright © 2020 Pearson Canada Inc. 3 - 38