Chapter 4 Adjustments, Financial Statements, and the Quality of Earnings
Chapter 4
Adjustments, Financial Statements, and the Quality of Earnings
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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.
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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
After we post the entry to the T-accounts, the account balances look like this:
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
After we post the entry to the T-accounts, the account balances look like this:
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
After we post the entry to the T-accounts, the account balances look like this:
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
After we post the entry to the T-accounts, the account balances look like this:
1/31 2,500
Bal. 85,500
Accumulated Depreciation
Depreciation Expense
1/31 2,500
Bal. 2,500
1/31 83,000
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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
REVENUES EXPENSES –NET INCOME =
Increase
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CONTRIBUTED CAPITAL
RETAINED EARNINGS
ASSETS LIABILITIES STOCKHOLDERS’ EQUITY = +
Increase
REVENUES EXPENSES –NET INCOME =
Increase
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Note that this statement has ONLY
revenues & expenses!
Earnings Per Share (EPS) must
be reported on the income statement.
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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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