Chap 004

Chapter 4

Adjustments, Financial Statements, and the Quality of Earnings

© 2004 The McGraw-Hill CompaniesMcGraw-Hill/Irwin

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Business BackgroundManagement is Management is responsible for responsible for preparing . . .preparing . . .

. . . Are useful . . . Are useful to investors to investors

and creditors.and creditors.

Financial Financial StatementsStatements

High Quality High Quality = Relevance = Relevance + Reliability+ Reliability


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Business Background

Revenues are recorded

when earned.

Expenses are recorded

when incurred.

Because transactions occur over time, ADJUSTMENTS are Because transactions occur over time, ADJUSTMENTS are required at the end of each fiscal period to get the revenues required at the end of each fiscal period to get the revenues

and expenses in the “right” period.and expenses in the “right” period.


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Accounting CycleDuring the period: Analyze transactions. Record journal entries. Post amounts to general

ledger.

At the end of the period: Adjust revenues and

expenses.

Prepare financial statements.

Disseminate statements to users.

Close revenues, gains, expenses, and losses to Retained Earnings.


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The Unadjusted Trial Balance

A listing of individual accounts, usually in financial statement order.

Ending debit or credit balances are listed in two separate columns.

Total debit account balances should = total credit account balances.


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Note that total debits = total credits


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The Unadjusted Trial BalanceIf total debits do not do not equal total credits on the

trial balance, errors have occurred . . .

in preparing balancedjournal entries.

in posting the correct dollareffects of a transaction.

in copying ending balancesfrom the ledger to the

trial balance.


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Accumulated depreciation is a contra-asset account. It is directly related to an asset account but has the opposite balance.


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Cost - Accumulated depreciation = Cost - Accumulated depreciation = BOOK VALUE.BOOK VALUE.


4-10Now that we havecovered the trial

balance, let’sdiscuss adjusting

entries.


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Adjusting EntriesThere are two types of adjusting entries.

ACCRUALSRevenues earned or expenses

incurred but no cash has been

exchanged.

DEFERRALSReceipts of assets or

payments of cash in advance

of revenue or expense

recognition.


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End of accounting period.

Cash receivedor paid.

Revenues earnedor

expense incurred

Examples include interest earned during the period (accrued revenue) or wages earned by employees but

not yet paid (accrued expense).

Accruals


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Accrued revenues

Accrued revenues: cash is received after revenues are earned

1 stepReceivable account +Revenue +

2 step (after cash is received)Receivable account –Cash +


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Accrued Revenue - Example 1On October 1, 2003, Webb, Inc. invests $10,000 for 6 months in a certificate of deposit that pays 6% interest

per year. Webb will not receive the interest until the CD matures on March 31, 2004. On December 31, 2003, Webb, Inc. must make an entry for the interest earned

so far.


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Accrued Revenue - Example 1

After we post the entry to the T-accounts, the account balances look like this:

Interest Receivable

12/31 150

Bal. 150

Interest Revenue

12/31 150

Bal. 150


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Accrued expenses

Accrued expenses: cash is paid after expenses are incurred

1 stepPayable account +Expense +

2 step (after cash is paid)Payable account –Cash -


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Accrued Expenses - Example 2As of 12/27/03, Denton, Inc. had already paid $1,900,000

in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/03, falls on a

Wednesday. The employees have earned total wages of $50,000 for Monday through Wednesday of the

week ended 1/02/04.


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Accrued Expenses - Example 2


Wages Payable

12/31 50,000

Bal. 50,000

Wages Expense

$1,900,000

Bal. $1,950,000

As of 12/2712/31 50,000


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End of accounting period.

Cash receivedor paid.

Revenues earnedor

expense incurred

Examples include rent received in advance (an Examples include rent received in advance (an unearned revenue) or insurance paid in unearned revenue) or insurance paid in

advance (a prepaid expense).advance (a prepaid expense).

Deferrals


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Deferred revenues

Deferred revenues: cash is received before revenues are earned

1 stepUnearned Revenue (L) +Cash +

2 step (after revenues are earned)Unearned revenue (L) –Revenue +


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Unearned Revenue - Example 1On December 1, 2003, Tom’s Rentals received a check

for $3,000, for the first four months’ rent of a new tenant.

The entry on December 1, 2003, to record the receipt of the prepaid rent payment would be . . .

This is a LIABILITY account


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Unearned Revenue - Example 2

We must record the amountWe must record the amountof rent of rent EARNEDEARNED during December. during December.

Since the prepayment is for Since the prepayment is for 4 4 monthsmonths, we can assume that 1/4 of , we can assume that 1/4 of the rent will be earned each month. the rent will be earned each month.

Received cash for rent

< 4-month prepayment of rent >

12/1/03 12/31/03Year end

2/28/041/31/04 3/31/04


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Unearned Revenue - Example 1On December 31, 2003, Tom’s Rentals must adjust the

Unearned Rent Revenue account to reflect that 1 month of rent revenue has been earned.

$3,000 × 1/4 = $750 per month.

In effect, our obligation to let them occupy the space for a period of has decreased, because they used the space for 1

month.


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Unearned Revenue - Example 1


Unearned Rent Revenue

12/31 750 12/1 3000

Bal. 2,250

Rent Revenue

12/31 750

Bal. 750


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Deferred expenses

Deferred expenses: cash is paid before expenses are incurred

1 stepPre-paid expense (A) +Cash -

2 step (after expenses are incurred)Pre-paid expense (A) –Expenses +


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Prepaid Expense - Example 2On January 1, 2003, Tipton, Inc. paid $3,600 for a 3-year

fire insurance policy. They are paying in advance for a resource they will use over a 3-year period.

The entry on January 1, 2003, to record the policy on Tipton’s books would appear as follows . . .

This is an ASSETASSET account


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Prepaid Expense - Example 2

At the end of 2003, we determine how much At the end of 2003, we determine how much of the “prepaid expense” has been used up of the “prepaid expense” has been used up

during the period. during the period. Since the policy is for Since the policy is for 3 years3 years, we can , we can

assume that 1/3 of the policy will expire assume that 1/3 of the policy will expire each year. each year.

1/1/03 12/31/03Year end

12/31/04Year end

12/31/05Year end

Paid cash forinsurance

< 3-year insurance policy >


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Prepaid Expense - Example 2On December 31, 2003, Tipton must adjust the Prepaid Insurance Expense account to reflect that 1 year of the

policy has expired.

$3,600 × 1/3 = $1,200 per year.

In effect, the prepaid asset goes down, while the expense goes up.


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Prepaid Expense - Example 2


PrepaidInsurance Expense

1/1 3,600 12/31 1,200

Bal. 2,400

Insurance Expense

12/31 1,200

Bal. 1,200


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Certain circumstances require adjusting entries to record accounting estimates.

Examples include . . .DepreciationBad debtsIncome taxes

$$$

Accounting Estimates


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Certain circumstances require adjusting entries to record accounting estimates.

Examples include . . .DepreciationBad debtsIncome taxes

Accounting Estimates

Let’s look at how we handle

Depreciation expense.


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Depreciation

The accounting concept of

depreciation involves the

systematic and rational allocation of a long-lived asset’s cost to the multiple periods it is used to generate revenue.

This is a “cost allocation” concept,

not a “valuation” concept.


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Recording Depreciation

The required journal entry requires a debit to Depreciation expense and a credit to an

account called Accumulated depreciation.

As discussed earlier, this is called a Contra-Asset account.


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Depreciation - Example 1At January 31, 2001, Papa John’s trial balance showed

Property & equipment of $338,000 (all numbers in thousands) and Accumulated depreciation of $83,000.

For the period, Papa John’s needs to record an additional $2,500 in depreciation.


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Depreciation - Example 1


1/31 2,500

Bal. 85,500

Accumulated Depreciation

Depreciation Expense

1/31 2,500

Bal. 2,500

1/31 83,000


4-36Financial Statement PreparationThe next step in the accounting cycle is

to prepare the financial statements. . .Income statement,Statement of stockholders’ equity,Balance sheet, andStatement of cash flows.


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The income statement is created first The income statement is created first by determining the difference by determining the difference

between revenues and expenses.between revenues and expenses.

Net income increases retained earnings, while a net loss will decrease retained earnings. Dividends decrease retained

earnings.

Financial Statement Relationships

RETAINED EARNINGS

REVENUES EXPENSES –NET INCOME =

DIVIDENDS Decrease

Increase


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STOCKHOLDERS’ EQUITY

Financial Statement Relationships

CONTRIBUTED CAPITAL

RETAINED EARNINGS

Contributed Capital and Contributed Capital and R/E make up R/E make up

Stockholders’ Equity.Stockholders’ Equity.Increase


Increase


4-39Financial Statement Relationships

CONTRIBUTED CAPITAL

RETAINED EARNINGS

ASSETS LIABILITIES STOCKHOLDERS’ EQUITY = +

Increase


Increase


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Note that this statement has ONLY

revenues & expenses!

Earnings Per Share (EPS) must

be reported on the income statement.


4-41Statement of Stockholders’ Equity

Net income appears on the statement of stockholders’ equity as an increase in Retained Earnings.


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Balance Sheet

$338,000 cost – $85,500

accumulated depreciation and

amortization.


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Balance Sheet - ContinuedRemember that Remember that Total liabilities Total liabilities

and stockholders’ and stockholders’ equity ($433,000) equity ($433,000) must equal Total must equal Total

assets ($433,000).assets ($433,000).


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Even though the balance sheet

account balances carry forward from

period to period, the income statement accounts do not.

Closing entries:1. Transfer net income (or

loss) to Retained Earnings.

2. Establish a zero balance in each of the temporary accounts to start the next accounting period.

The Closing Process


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Temporary accounts are closed at the end of the period.

Revenues Expenses Gains, losses Dividends declared

The Closing Process


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Assets, liabilities, and stockholders’ equity are permanent, or real accounts, and are never

closed.

AssetsLiabilitiesStockholders’

Equity

The Closing Process


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Two steps are used in the closing process

. . .1. Close revenues

and gains to Retained Earnings.

2. Close expenses and losses to Retained Earnings.

How toClose

theBooks!

The Closing Process


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To close Papa John’s Restaurant Sales Revenue account, the following entry is required:

The Closing Process


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If we close the other revenue accounts

in a similar fashion,

the retained earnings account

looks like this . . .

The Closing Process


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To close Papa John’s Cost of Sales - Restaurants account, the following entry is required:

The Closing Process


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If we close the other expense

accounts in a similar

fashion, the retained earnings account

looks like this . . .

The Closing Process


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Finally, we close

dividends to Retained

Earnings and the account balances out to $169,241

and looks like this . . .

The Closing Process


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End of Chapter 4

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