Chapter 4: Adjustments, Financial Statements, and Financial Results

Learning Objective 1

Explain why adjustments are needed.

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Solution: Adjustments are made to the accounting records at the end of the period to state assets, liabilities, revenues,

and expenses at appropriate amounts.

Why Adjustments Are Needed

However, cash is not always received in the period in which the company earns the related revenue;

likewise, cash is not always paid in the period in which the company incurs the related expense.

Accounting systems are designed to record most recurring daily transactions, particularly any

involving cash.

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Why Adjustments Are Needed

Income Statement•Revenues are recorded when earned.•Expenses are recorded in the same period as the revenues to which they relate.

Balance Sheet•Assets are reported at amounts representing the economic benefits that remain at the end of the period. •Liabilities are reported at amounts owed at the end of the period.

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Adjustments help to ensure that all revenues and expenses are reported in the period in which they are earned and incurred.

Without adjustments, the financial statements present an incomplete and misleading picture of the company’s

financial performance.

1. Deferral AdjustmentsAn expense or revenue has been deferred if we have

postponed reporting it on the income statement until a later period.

Sept. 1 Sept. 30Use-up rent benefits

Cash paid for rent in advance

Adjustment needed

Jan. 1 Jan. 31Deliver

subscription service

Cash received for subscription

in advance

Adjustment needed

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1. Deferral Adjustments

Deferral adjustments are used to decrease balance

sheet accounts and increase corresponding

income statement accounts.

Each deferral adjustment involves one asset and

one expense account, or one liability and one

revenue account.

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2. Accrual AdjustmentsAccrual adjustments are needed when a company has earned revenue or incurred an expense in the current period but has not yet recorded it because the related cash will not be received or paid until a later period.

Sept. 1 Sept. 30Incur income taxes

Adjustment needed

Jan. 1 Jan. 31Earn interest

Adjustment needed

Dec. 31

Cash paid for income taxes

Mar. 31

Cash received for interest

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2. Accrual Adjustments

Accrual adjustments are used to record revenue or expenses when they occur prior to receiving or paying cash, and to adjust corresponding

balance sheet accounts.

Each accrual adjustment involves one asset and

one revenue account, or one liability and one

expense account.

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Learning Objective 2

Prepare adjustments needed at the end of the period.

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Making Required Adjustments

Adjustments are not made on a daily basis because it’s more efficient to do them all at once

at the end of each period.

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Adjustment Analysis, Recording and Summarizing

1 Analyze

Determine the necessary adjustments to make to the accounting records.

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Deferral Adjustments(a) Supplies Used during the Period.

Of the $1,600 in supplies received in early September, $400 remain on hand at September 30.

Assets = Liabilities + Stockholders' Equity(a) Supplies -1,200 Supplies

Expense (+E) -1,200

1 Analyze

2 Record

(a) dr Supplies Expense (+E, -SE) 1,200 cr Supplies (-A) 1,200

3 Summarize

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Deferral Adjustments(b) Rent Benefits Expired during the Period.

Three months of rent were prepaid on September 1 for $7,200, but one month has now expired, leaving only two months prepaid at September 30.

1/3 x $7,200 = $2,400 expense used up as of Sept. 30

2/3 x $7,200 = $4,800 asset remains prepaid as of Sept. 30

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Deferral Adjustments

Three months of rent were prepaid on September 1 for $7,200, but one month has now expired, leaving only two months prepaid at September 30.

Assets = Liabilities + Stockholders' Equity(b) Prepaid Rent Rent -2,400 Expense (+E) -2,400

1 Analyze

2 Record

(b) dr Rent Expense (+E, -SE) 2,400 cr Prepaid Rent (-A) 2,400

3 Summarize

(b) Rent Benefits Expired during the Period.

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Deferral Adjustments(c) Depreciation Is Recorded for Use of Equipment.

The restaurant equipment, which was estimated to last five years, has now been used for one month, representing an estimated expense of $1,000.

Depreciation is the process of allocating the cost of buildings, vehicles, and equipment to the accounting

periods in which they are used.

A contra-account is an account that is an offset to, or

reduction of, another account.

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Deferral Adjustments

The restaurant equipment, which was estimated to last five years, has now been used for one month, representing an estimated expense of $1,000.

Assets = Liabilities + Stockholders' Equity(c) Accumulated Depreciation Depr. +1,000 Expense (+E) +1,000

1 Analyze

2 Record

(c) dr Depreciation Expense (+E, -SE) 1,000 cr Accumulated Depreciation (+xA, -A) 1,000

3 Summarize

(c) Depreciation Is Recorded for Use of Equipment.

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Depreciation

Accumulated Depreciation

Balance Sheet

Depreciation Expense

Income Statement

Note 1

Accumulated Depreciation

Total Amount

Depreciated

Equipment

Original cost

Note 2

Contra-Account

Opposes account it

offsets

Note 3

Depreciation Amount

Depends on method used

Note 4

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Deferral Adjustments(d) Gift Cards Redeemed for Service.

Pizza Aroma redeemed $160 of gift cards that customers used to pay for pizza.

Assets = Liabilities + Stockholders' Equity(d) Unearned Pizza

Revenue -160 Revenue (+R) +160

1 Analyze

2 Record

(d) dr Unearned Revenue (-L) 160 cr Pizza Revenue (+R, +SE) 160

3 Summarize

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Accrual Adjustments(e) Revenues Earned but Not Yet Recorded.

Pizza Aroma provided $40 of Pizza to Mauricio’s close friend on the last day of September, with payment to be received in October.

Assets = Liabilities + Stockholders' Equity(e) Accounts Pizza Receivable +40 Revenue (+R) +40

1 Analyze

2 Record

(e) dr Accounts Receivable (+A) 40 cr Pizza Revenue (+R, +SE) 40

3 Summarize

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Accrual Adjustments(f) Wages Expense Incurred but Not Yet

Recorded.Pizza Aroma owes $900 of wages to employees for work done in the last three days of September.

Assets = Liabilities + Stockholders' Equity(f) Wages Wages Payable +900 Expense (+E) -900

1 Analyze

2 Record

(f) dr Wages Expense (+E, -SE) 900 cr Wages Payable (+L) 900

3 Summarize

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Accrual Adjustments(g) Interest Expense Incurred but Not Yet Recorded.

Pizza Aroma has not paid or recorded the $100 interest that it owes for this month on its note payable to the bank.

Assets = Liabilities + Stockholders' Equity(g) Interest Interest Payable +100 Expense (+E) -100

1 Analyze

2 Record

(g) dr Interest Expense (+E, -SE) 100 cr Interest Payable (+L) 100

3 Summarize

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Accrual Adjustments(h) Income Taxes Incurred but Not Yet Recorded.

Pizza Aroma pays income tax at an average rate equal to 40 percent of the company’s income before taxes.

Assets = Liabilities + Stockholders' Equity(h) Income Tax Income Tax Payable +400 Expense (+E) -400

1 Analyze

2 Record

(h) dr Income Tax Expense (+E, -SE) 400 cr Income Tax Payable (+L) 400

3 Summarize$1,000 x 40% = $400

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Additional Comments

Adjusting journal entries never involve cash.

Adjusting entries always include one balance sheet and one income statement

account.

Dividends are not expenses. Instead, they are a reduction of the retained

earnings.

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Pizza Aroma’s Accounting Records

(i) Dividend Declared and Paid.

Pizza Aroma declares and pays a $500 cash dividend.

Assets = Liabilities + Stockholders' Equity(i) Cash -500 Dividends Declared (+D) -500

1 Analyze

2 Record

(i) dr Dividends Declared (+D, -SE) 500 cr Cash (-A) 500

3 Summarize

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Learning Objective 3

Prepare an adjusted trial balance.

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Debit CreditCash 7,600$ Accounts Receivable 240 Supplies 400 Prepaid Rent 4,800 Cookware 630 Equipment 60,000 Accumulated Depreciation 1,000$ Accounts Payable 1,030 Unearned Revenue 140 Wages Payable 900 Income Tax Payable 400 Interest Payable 100 Note Payable 20,000 Contributed Capital 50,000 Retained Earnings - Dividends Declared 500 Pizza Revenue 15,700 Wages Expense 9,000 Rent Expense 2,400 Supplies Expense 1,200 Depreciation Expense 1,000 Utilities Expense 600 Advertising Expense 400 Interest Expense 100 Income Tax Expense 400 Total 89,270$ 89,270$

PIZZA AROMAAdjusted Trial Balance

As of September 30, 2010

Partial Listing of T-accounts

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Learning Objective 4

Prepare financial statements.

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Debit CreditCash 7,600$ Accounts Receivable 240 Supplies 400 Prepaid Rent 4,800 Cookware 630 Equipment 60,000 Accumulated Depreciation 1,000$ Accounts Payable 1,030 Unearned Revenue 140 Wages Payable 900 Income Tax Payable 400 Interest Payable 100 Note Payable 20,000 Contributed Capital 50,000 Retained Earnings - Dividends Declared 500 Pizza Revenue 15,700 Wages Expense 9,000 Rent Expense 2,400 Supplies Expense 1,200 Depreciation Expense 1,000 Utilities Expense 600 Advertising Expense 400 Interest Expense 100 Income Tax Expense 400 Total 89,270$ 89,270$

PIZZA AROMAAdjusted Trial Balance

As of September 30, 2010

RevenuesPizza Revenue 15,700$ Total Revenue 15,700

ExpensesWages Expense 9,000 Rent Expense 2,400 Supplies Expense 1,200 Depreciation Expense 1,000 Utilities Expense 600 Advertising Expense 400 Interest Expense 100 Income Tax Expense 400 Total Expenses 15,100 Net Income 600$

For the Month Ended September 30, 2010Income StatementPIZZA AROMA, INC.

Retained Earnings, Sept. 1, 2010 -$ Add: Net Income 600 Subtract: Dividends Declared (500) Retained Earnings, Sept. 30, 2010 100$

For the Month Ended September 30, 2010

PIZZA AROMA, INC.Statement of Retained Earnings

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Debit CreditCash 7,600$ Accounts Receivable 240 Supplies 400 Prepaid Rent 4,800 Cookware 630 Equipment 60,000 Accumulated Depreciation 1,000$ Accounts Payable 1,030 Unearned Revenue 140 Wages Payable 900 Income Tax Payable 400 Interest Payable 100 Note Payable 20,000 Contributed Capital 50,000 Retained Earnings - Dividends Declared 500 Pizza Revenue 15,700 Wages Expense 9,000 Rent Expense 2,400 Supplies Expense 1,200 Depreciation Expense 1,000 Utilities Expense 600 Advertising Expense 400 Interest Expense 100 Income Tax Expense 400 Total 89,270$ 89,270$

PIZZA AROMAAdjusted Trial Balance

As of September 30, 2010

Current Assets

Cash 7,600$

Accounts Receivable 240

Supplies 400

Prepaid Rent 4,800

Cookware 630

Total Current Assets 13,670

Equipment 60,000$

Accumulated Depreciation (1,000) 59,000

Total Assets 72,670$

Liabilities

Current Liabilities

Accounts Payable 1,030$

Unearned Revenue 140

Wages Payable 900

Income Tax Payable 400

Interest Payable 100

Total Current Liabilities 2,570

Note Payable 20,000

Total Liabilities 22,570

Stockholders' Equity

Contributed Capital 50,000

Retained Earnings 100

Total Stockholders' Equity 50,100

Total Liabilities and Stockholders' Equity 72,670$

PIZZA AROMA, INC.

Balance Sheet

At September 30, 2010

Assets

Liabilities and Stockholders' Equity

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Learning Objective 5

Explain the closing process.

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Closing Temporary Accounts

Transfer net income (or loss) and dividends to

Retained Earnings.

Establish zero balances in all income statement and dividend accounts.

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Temporary accounts track financial

results for a limited period of time.

Temporary accounts track financial

results for a limited period of time.

Closing Temporary Accounts

Revenues

Exp

ense

s

Divid

end

s

TemporaryAccounts

Permanent Accounts

Assets

Lia

bili

ties E

qu

ity

Permanent accounts track financial

results from year to year.

Permanent accounts track financial

results from year to year.

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Two closing journal entries are needed.

Closing Temporary Accounts

Debit Revenue accounts and credit Expense accounts. Debit or credit the difference to Retained Earnings.

Credit Dividends Declared and debit Retained Earnings.

Debit Revenue accounts and credit Expense accounts. Debit or credit the difference to Retained Earnings.

Credit Dividends Declared and debit Retained Earnings.

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dr Pizza Revenue (-R) 15,700 cr Wages Expense (-E) 9,000 cr Rent Expense (-E) 2,400 cr Supplies Expense (-E) 1,200 cr Depreciation Expense (-E) 1,000 cr Utilities Expense (-E) 600 cr Advertising Expense (-E) 400 cr Interest Expense (-E) 100 cr Income Tax Expense (-E) 400 cr Retained Earnings (+SE) 600

dr Retained Earnings (-SE) 500 cr Dividends Declared (-D) 500

Debit CreditCash 7,600$ Accounts Receivable 240 Supplies 400 Prepaid Rent 4,800 Cookware 630 Equipment 60,000 Accumulated Depreciation 1,000$ Accounts Payable 1,030 Unearned Revenue 140 Wages Payable 900 Income Tax Payable 400 Interest Payable 100 Note Payable 20,000 Contributed Capital 50,000 Retained Earnings - Dividends Declared 500 Pizza Revenue 15,700 Wages Expense 9,000 Rent Expense 2,400 Supplies Expense 1,200 Depreciation Expense 1,000 Utilities Expense 600 Advertising Expense 400 Interest Expense 100 Income Tax Expense 400 Total 89,270$ 89,270$

PIZZA AROMAAdjusted Trial Balance

As of September 30, 2010

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After posting these closing entries, all

the income statement accounts

and the dividend account will have a

zero balance.

dr Pizza Revenue (-R) 15,700 cr Wages Expense (-E) 9,000 cr Rent Expense (-E) 2,400 cr Supplies Expense (-E) 1,200 cr Depreciation Expense (-E) 1,000 cr Utilities Expense (-E) 600 cr Advertising Expense (-E) 400 cr Interest Expense (-E) 100 cr Income Tax Expense (-E) 400 cr Retained Earnings (+SE) 600

dr Retained Earnings (-SE) 500 cr Dividends Declared (-D) 500

Closing Temporary Accounts

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Post-Closing Trial BalanceFinal check that all

debits still equal credits and that all

temporary accounts have been closed.

Contains balances for only permanent

accounts.

Is the last step in the accounting process.

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