Adjustments, Financial Statements, and the Quality of Earnings

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Chapter 4

• Adjustments, Financial Statements, and the
  Quality of Earnings

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Business Background
Management is responsible for preparing . . .
Financial Statements
High Quality Relevance Reliability
. . . Are useful to investors and creditors.
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Business Background
Revenues are recorded when earned.
Expenses are recorded when incurred.
Matching Principle
Because transactions occur over time, ADJUSTMENTS
are required at the end of each fiscal period to
get the revenues and expenses in the right
period.
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Accounting Cycle

• During the period
• Analyze transactions.
• Record journal entries.
• Post amounts to general ledger.

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

• Prepare financial statements.
• Disseminate statements to users.

• At the end of the period
• Adjust revenues and expenses.

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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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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 BOOK VALUE.
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The Unadjusted Trial Balance

• If total debits do not equal total credits on the
  trial balance, errors have occurred . . .

in preparing balanced journal entries.
in posting the correct dollar effects of a
transaction.
in copying ending balances from the ledger to
the trial balance.
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Now that we have covered the trial balance,
lets discuss adjusting entries.
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Adjusting Entries

• There are two types of adjusting entries.

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Deferrals
End of accounting period.
Examples include rent received in advance (an
unearned revenue) or insurance paid in advance (a
prepaid expense).
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Prepaid Expense - Example 1

• On 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 Tiptons books would appear
  as follows . . .

This is an ASSET account
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Prepaid Expense - Example 1
Paid cash for insurance
lt 3-year insurance policy gt
1/1/03
12/31/03 Year end
12/31/04 Year end
12/31/05 Year end
At the end of 2003, we determine how much of the
prepaid expense has been used up during the
period. Since the policy is for 3 years, we can
assume that 1/3 of the policy will expire each
year.
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Prepaid Expense - Example 1

• On 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 1

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

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Deferrals

• Now, lets look at an
• example of
• cash received
• in advance.

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Unearned Revenue - Example 2

• On December 1, 2003, Toms 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
Received cash for rent
lt 4-month prepayment of rent
gt
We must record the amount of rent EARNED during
December. Since the prepayment is for 4 months,
we can assume that 1/4 of the rent will be earned
each month.
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Unearned Revenue - Example 2

• On December 31, 2003, Toms 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 2

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

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Accruals
Now, we need to look at adjusting entries for
accruals.
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Accruals

• Accruals occur when revenues have been earned or
  expenses incurred but no cash has been exchanged.

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Accruals
End of accounting period.
Examples include interest earned during the
period (accrued revenue) or wages earned by
employees but not yet paid (accrued expense).
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Accrued Revenue - Example 1

• On 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

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Accrued Expenses - Example 2

• As 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

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Accounting Estimates

• Certain circumstances require adjusting entries
  to record accounting estimates.
• Examples include . . .
• Depreciation
• Bad debts
• Income taxes

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Accounting Estimates

• Certain circumstances require adjusting entries
  to record accounting estimates.
• Examples include . . .
• Depreciation
• Bad debts
• Income taxes

Lets 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 assets 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 1

• At January 31, 2001, Papa Johns trial balance
  showed Property equipment of 338,000 (all
  numbers in thousands) and Accumulated
  depreciation of 83,000. For the period, Papa
  Johns 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

Accumulated Depreciation
1/31 83,000
1/31 2,500
Bal. 85,500
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Financial Statement Preparation

• The next step in the accounting cycle is to
  prepare the financial statements. . .
• Income statement,
• Statement of stockholders equity,
• Balance sheet, and
• Statement of cash flows.

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Financial Statement Relationships
Net income increases retained earnings, while a
net loss will decrease retained earnings.
Dividends decrease retained earnings.
The income statement is created first by
determining the difference between revenues and
expenses.
RETAINED EARNINGS
DIVIDENDS
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Financial Statement Relationships
Contributed Capital and R/E make up Stockholders
Equity.
STOCKHOLDERS EQUITY
CONTRIBUTED CAPITAL
RETAINED EARNINGS
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Financial Statement Relationships
CONTRIBUTED CAPITAL
RETAINED EARNINGS
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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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Statement 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 - Continued
Remember that Total liabilities and stockholders
equity (433,000) must equal Total assets
(433,000).
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Statement of Cash Flows

• This statement is a categorized list of all
  transactions of the period that affected the Cash
  account. The three categories are . . .
• Operating activities,
• Investing activities, and
• Financing activities.

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Statement of Cash Flows - General Model
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Key Ratio Analysis Net Profit Margin
Net Profit Margin gives an indication of how
effective management is at generating profit on
every dollar of sales.
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Key Ratio Analysis Net Profit Margin
The 2000 net profit margin for Papa Johns is
based on net income of 32,000,000 and on sales
of 945,000,000, giving them a net profit margin
of 3.39.
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The Closing Process

• Even though the balance sheet account balances
  carry forward from period to period, the income
  statement accounts do not.

• Closing entries
• Transfer net income (or loss) to Retained
  Earnings.
• Establish a zero balance in each of the temporary
  accounts to start the next accounting period.

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The Closing Process

• The following accounts are called temporary or
  nominal accounts and are closed at the end of the
  period . . .

• Revenues
• Expenses
• Gains,
• Losses, and
• Dividends declared.

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The Closing Process

• Assets, liabilities, and stockholders equity
  are permanent, or real accounts, and are never
  closed.

• Assets
• Liabilities
• Stockholders Equity

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The Closing Process

• Two steps are used in the closing process . . .
• Close revenues and gains to Retained Earnings.
• Close expenses and losses to Retained Earnings.

How to Close the Books!
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The Closing Process
To close Papa Johns Restaurant Sales Revenue
account, the following entry is required
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The Closing Process

• If we close the other revenue accounts in a
  similar fashion, the retained earnings account
  looks like this . . .

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The Closing Process
To close Papa Johns Cost of Sales -
Restaurants account, the following entry is
required
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The Closing Process

• If we close the other expense accounts in a
  similar fashion, the retained earnings account
  looks like this . . .

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The Closing Process

• Finally, we close dividends to Retained
  Earnings and the account balances out to 169,241
  and looks like this . . .

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End of Chapter 4
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